We get a lot of questions on the tax benefits of real estate and the role of depreciation in real estate transactions. This post gives an example of the tax implications of purchasing a single condo, renting it out for 10 years, and then selling it.
For this example we make the following assumptions:
- We have income from a source other than this condo, such as W2 income from an employer.
- Our marginal tax rate is 35%.
- We are not real estate professionals so the income from this condo is passive. We carry over our losses every year.
Purchase
Assume we buy the condo for $500,000. The condo brings in $30,000 in rent each year, and we pay $20,000 a year in expenses. Also let’s assume the condo is worth $400,000 and the land is $100,000. The IRS only allows us to deduct based on the value of the land so in this case, our yearly depreciation is $400,000/29.5 = $13,560.
These are the assumptions upon buying the condo:
| Initial property value | $500,000 |
| Land value | $100,000 |
| Building value | $400,000 |
| Annual Depreciation | $13,560 |
| Annual Income | $10,000 |
| Annual passive loss carryover | $3,560 |
We declare a loss each year, so we won’t have to pay taxes on our income until we sell the property.
Sale
Now let’s look at what happens when we sell. We will sell the property after 10 years for $700,000.
These are the assumptions when sold:
| Selling Price | $700,000 |
| Capital Gain | $200,000 |
| Depreciation Recapture | $135,600 |
| Total Passive Loss Carryover | $35,600 |
We will have to pay long-term capital gains tax on $200,000. Capital gains tax rates range from 0 to 23%. There are strategies to postpone paying capital gains tax but those are outside the scope of this post.
We also "recapture" $135,600 in depreciation that we've accrued while we've owned the property, meaning that we now have to pay taxes on it. Depreciation recapture tax is capped at 25%. People wonder why they have to pay tax on depreciation since depreciation isn’t income. Here’s how we can break it down:
$100,000 of the recapture is from the income we’ve made on the property through our ownership period (10 years at $10,000 a year). We knew we’d eventually have to pay taxes on that money. If we would have paid that tax yearly, we would have paid our marginal tax rate of 35%, but because we deferred it through depreciation, we only pay 25%. Not only did we get to defer paying taxes, but we ended up paying a lesser rate.
We also have $35,600 of passive loss carryover that we can now use because we’ve sold the property. That money gets subtracted from our total income for the year. In essence this means that we pay 25% tax on $35,600 of income that we normally would have paid 35% on.
Summary
For our rental condo, we gained three tax benefits:
- we deferred taxes on $100,000 in income until we sold the property.
- The tax rate on our income was 25% instead of 35%. This saved us $10,000.
- We converted $35,600 of other income from being taxed at 35% to being taxed at 25%. This saved us $3,560.
If you have any questions or comments on this blog post or need a bookkeeper for your small business, contact us at: info@currentlifeventures.com