Of all the articles I’ve written about the amazing financial benefits of rental properties, I realize now that I’ve left out one of the biggest perks of owning a residential rental property. Someone in a recent comment on one of my articles mentioned it, and my jaw dropped thinking about how I’ve not spent a lot of time talking about this!
Are you ready?
Let me warm up your suspense a little bit. I’ve done quite a few articles and videos showing how to run cash flow calculations on a prospective rental property. For example, check out “Rental Properties So Easy You Can Calculate Them on a Napkin.”
A question that gets asked several times regarding my cash flow calculations is, “Where do you account for the taxes you have to pay on that income?”
Why do readers ask that question? Well, it’s because I don’t include it in the numbers. Why don’t I?
Are you ready for one of the biggest financial perks of owning residential rental properties as an investment?
You don’t have to pay taxes on income received from residential rental properties!
A Few Caveats
Before I even go any further, I’m going to tell you right now that I am not a tax expert. Like with all investments or business things, I highly recommend you consult a professional in this field for exact and more accurate details. In the case of taxes, I highly recommend you work with an accountant who specializes in real estate investing. Trust me, not all of them do. If you own real estate investments, I think you are crazy if you don’t let a professional do your taxes. Tax benefits are one of the strongest perks of owning property, and I promise you that TurboTax or your local H&R Block are not suited for the challenge of maximizing your benefits for you.
Another caveat to this claim is that yes, you end up not having to pay taxes on rental property income, but you don’t go about that by just not paying anything or filing anything. There are some things you have to do in order to make your income tax-free, and you have to do those things right. But it’s not hard, and if you work with a professional to make sure it’s done correctly, it’s easy peasy.
The Magic of Depreciation
I have yet to have ever paid any taxes on the income I get from my rental properties. Am I a sneaky felon con who wiggles my way around paying taxes? Absolutely not. Not paying taxes on rental property income is VERY legal! In fact, it gets even better than that. Not only have I never paid taxes on my rental property income, but I’ve also ended up claiming “losses” on them. That “loss” then gets put towards my other life income, so I actually end up profiting more money on top of just not having to pay taxes! Again, all very legal.
Ultimately, how this works is: The amount of deductions you are allowed to write-off on a rental property typically exceeds the amount you receive in rents. Therefore, if you (legally) write off as much or more than you made on the property, there’s nothing left to pay tax on!
But how do the write-offs possibly total more than what you bring in? I’ll give you one word — depreciation.
What Exactly is Depreciation?
Depreciation is a term used by the IRS to say that properties lose value over time. The condition of the property, for example, has to deteriorate with time. Even if your property is appreciating in value, the IRS still considers your property to be depreciating as well.
Residential rental properties are the only asset class that both go up in value and down in value, all at the same time!
The way the IRS handles depreciation is by letting you write off what they determine to be an appropriate amount for depreciation based on the value of the structure (not the land) of your property. I’m not going to go into extreme details on how this calculation works, but the basic idea is that you first determine the value of the property structure (subtract land value from the total value to end up with the value of the structure). You then divide that number by 27.5 because the IRS bases all of this off a 27.5 year straight-line schedule. Then the number you are left with, per year, you can write off as a “loss.”
For example, if the value of the structure of your property is worth $140,000, dividing that by 27.5 comes out to just over $5,000 per year. You get to write off $5,000 per year! They call this a “phantom loss” because you never actually lost the money. How great is that? Writing off money you never actually lost! Yes, please.
So, you would take this $5,000 per year (or whatever your number is) and then add to that mortgage interest (which can be a lot as well), operating expenses (property tax, insurance, repairs — not capital improvements), travel expenses, and property management fees and HOA fees if applicable. All of those things combined equate to what you are going to write off against the income the property brought in.
There is a very good chance that all of those expenses combined (including the phantom depreciation loss) equal more than you earned. If it equals how much you brought in, you pay no taxes. If it’s more than what you brought in, you can take that “loss” against your other forms of income! This could save you even more in taxes, or depending on your tax bracket and income levels, it might even knock you down into a lower tax bracket overall. So then you pay even less taxes.
Get a Good Accountant
As I said, for details on all of this, consult a professional accountant (preferably specializing in real estate investing). There are some contingencies on exactly how much can be taken from where, but those contingencies don’t negate the principle of how and why your income from residential rental properties typically ends up being tax-free.