Real Estate Depreciation and Tax Sheltering

Because of the progressive tax system used in the United States, it's extremely difficult for most people to accumulate any real savings from their work salary alone. Under the progressive tax, the more money you make the more taxes you must pay. Even when you do manage to save, the interest that you earn is taxed as ordinary income, pushing you inevitably closer to higher and more expensive federal and state tax brackets. Such tax laws actually have the net effect of penalizing those who successfully increase their earnings or who find ways to save money and earn interest on their savings.

Although tax evasion is a federal crime, tax avoidance certainly is not; what's more, it's not only legal, it makes good sense. As a matter of fact, it's quite possible for an investor to operate within the framework of the tax laws, generate significant spendable income, and pay few (if any) income taxes. The current weakness of the housing and mortgage industries notwithstanding, real estate continues to be one of the most effective tax-sheltering vehicles available.

Put bluntly, real estate makes good tax sense. To begin with, property taxes are deductible. Next, interest paid on home purchase loans for both a principal residence and a second home are also deductible, provided that the loan balance doesn't exceed the cost of the residence plus improvements and the indebtedness on the principal residence (plus the secondary residence) doesn't exceed $1 million. (There's no limit for debts incurred before October 13, 1987.) Furthermore, you can refinance real estate and obtain non-taxable cash as income and use the interest you pay as a deductible expense. Additionally, interest on home equity loans up to $100,000 is tax-deductible as well, as long as all combined loans on the home don't exceed the property's fair market value. And for business and investment properties, all interest is tax-deductible without limit.

Depreciation makes real estate a favorable investment choice because it's also treated as an expense for tax purposes. While only an expense on paper (since the owner actually pays nothing for it), it can nonetheless offset or shelter other income from taxation. The IRS realizes that assets such as an apartment building or shopping mall will not last forever. They therefore allow an owner to deduct an amount as depreciation that allows the owner to recoup his or her investment. Each year the investor deducts the amount of depreciation from the property's cost basis, which is the owner's cost plus improvements made, less any depreciation that the owner has already taken.

Only property held for business and investment purposes can be depreciated, and then only the improvements; land can never be depreciated. Therefore, a homeowner cannot depreciate his or her own home. It is possible, however, to depreciate portions of a home used solely for business purposes, as long as the homeowner has no other office. Residential property (apartment buildings, for example) must be depreciated over 27.5 years, while nonresidential property is depreciated over 39 years. A straight-line method of depreciation is used for tax purposes, which means that an equal amount is depreciated each year until the asset has been fully depreciated. For a residential property the depreciation would therefore be 1/27.5 per year over a 27.5-year lifespan, or 3.636 percent per year (100%/27.5 = 3.636%). So, if a depreciable improvement cost $150,000, the owner could take $5,455 each year as a depreciation expense until the asset was fully depreciated.

To obtain the greatest amount of depreciation, most investors attempt to apportion as much of their property's purchase price as possible to improvements and as little as possible to the land (remember, land can't be depreciated). One method frequently employed is to use the same proportion of land-to-value as the tax assessor does. For example, if the tax assessor has shown 95 percent of the property's value attributable to improvements and only 5 percent to land, the investor will use this apportionment – even though it might not necessarily reflect a proper distribution. The IRS will generally accept the tax assessor's value apportionment.

Historically, real estate has proved to be a significant tax shelter. As an example, let's assume that a property has a cash flow of $5000 (in other words, the cash income from the property exceeds cash expenditures by $5000 for the year). So, the investor has $5000 spendable cash in his or her pocket. If it were also depreciated $10,000 in that year, the property would actually have suffered a paper loss of $5000. Not only would the $5000 in spendable income be untaxed, the remaining $5000 loss could be used to offset $5000 of other income. Thus, the depreciation "shelters" the other income from taxation.

Unfortunately, the Tax Reform Act of 1986 has limited this tax shelter. All real estate losses are considered passive losses (losses that are incurred through an enterprise which the investor is not actively involved). Passive losses can now only be used to offset passive income. In other words, if you show a loss on one property of $50,000, it can offset $50,000 in what would otherwise be taxable income from another property. The tax law also limits a taxpayer's ability to shelter active income (income from wages and other activities) with passive losses.

For instance, investors with an adjusted gross income (AGI) of less than $100,000 can use passive real estate losses to shelter up to $25,000 of income from other sources. For taxpayers with between $100,000 and $150,000 of adjusted gross income, this shelter has been phased out. For each two dollars of AGI over $100,000, the $25,000 limit is reduced by one dollar. Therefore, an investor whose adjusted gross income is $120,000 would be limited to a $15,000 tax shelter. This investor could still use real estate losses to offset $15,000 of active income as well as unlimited gains from other passive real estate investments.

A further limitation imposed by the 1986 Tax Reform Act is that investors who don't actively manage their properties can't use their passive losses to shelter any active income. This means that investors who purchased shares in limited partnerships or similar investments can no longer use these paper losses from depreciation as a shelter against other income.