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The biggest tax benefit of investing in real estate is that you can make net income from your investment, you get your rental income, you pay your insurance, mortgage interest, real estate tax, your other expenses, and you have money leftover. You can then apply what’s called depreciation against the property. Depreciation is the rational allocation of the purchase price of the property that you can then deduct on an annual basis. Typically, residential apartment buildings depreciate over 27.5 years. For example, you pay $2,750,000 for an apartment building, you’ll get $100,000 of depreciation expensive a year, which means that I could have $100,000 of net cash flow from that building offset the depreciation and have zero taxable income. But I still have $100,000 in my bank account that I get to keep that I don’t have to pay taxes on.
The other benefit is that you can leverage your investment with debt. If I buy stocks, for example, in the stock market, and I want to buy $20,000 worth of stocks, for $20,000 I buy $20,000 worth of stocks. If I have $20,000 to buy real estate I can buy a $100,000 property, you get a mortgage for the other $80,000. That gives me the ability to get a return on investment that is typically higher than what I could earn in the market, combine that with the fact that I’m not paying any taxes on it, and it’s an even higher return on investment.
When real estate professionals are able to deduct everything and pay no tax, there are some drawbacks. Can you elaborate on what some of those drawbacks can be?
The primary one is recapture when they sell the property. That guy for example, when he goes to sell that property, he has $400,000 of recapture tax. It’s a deferral, it’s not an avoidance. With cost segregation you make money on the time value of money, because you’re going to pay that money back when you sell the property eventually, unless you do a 1031 exchange. In this scenario, I’ve already warned him that somewhere down the road, when you sell the property, there’s going to be a big capital gain, because your cost basis is a lot lower.
And that’s something that I’m talking with people all the time about, because everybody has been using bonus depreciation and taking huge offsets against their earned income, the ones that qualify as real estate professionals, and I keep telling them, when you sell that property, you will have to pay those taxes. Also, that bonus depreciation is actually set to phase out. Starting in 2023, it goes down from 100% bonus depreciation to 80%, then 60% in 2024, 40% in 2025, 20% in 2026 and in 2027 it’s gone. The strategy now if you sell properties is I’ll just go buy another, if I can’t do a 1031 exchange, I’ll go buy another property and just get new cost segregation and wipe out the gain on the property. That strategy has two more years of useful life, and then it’s going to become a lot less valuable, and then it’s going to be gone.
What about the fact that they might not be able to get a personal loan?
That’s a really good point. I was just telling someone this exact same scenario, which is good tax strategy and good asset protection don’t always correspond with good finance. Sometimes you can take so many tax deductions that you can’t get a loan. Typically, banks will add back depreciation, it’s not a cash flow issue, it’s an allocation of the purchase price.