Investing in real estate can add a new layer of diversification to your portfolio beyond traditional stocks and bonds, as well as providing the potential for a regular income stream. That said, you shouldn’t jump into being a landlord without paying attention to the details. Real property comes with a different set of tax rules. Depreciation, recapture, exclusion, and different capital gain rates can complicate the accounting and decision-making process. Today’s take home point: Keep good records!
The most commonly misunderstood concept when renting out real estate is depreciation. Even though rental property may go up in value, it’s still depreciated from a tax standpoint. Essentially, the starting value of the home is slowly deducted over a 27½ year span. How does one depreciate a home? Start with the fair market value of the home on the day it was placed into service as a business asset. From there, divide the value by 27.5 to arrive at the annual deprecation amount. Real estate is considered to be placed in service in the middle of the month, regardless of the actual date. So whether it is placed in service on June 1st or June 30th, half a month of the pro-rated depreciation is claimed. Take note: land is not depreciable. Only the value of the home is depreciated, not the entire property.
Knowing how much tax is owed may impact a selling decision. Consider these common roadblocks:
- Unlike stocks, which are taxed at a 15% long-term capital gains rate for most people, real estate sales also have to pay back deprecation, which is at a rate of 25%.
- Minor repairs and property improvements are accounted for differently. Fixing a leaky faucet and adding a new roof are not the same in the eyes of the IRS. The latter is considered a “capitalization” and is added to the depreciation schedule.
- Neglecting to claim the depreciation deduction in the first place in the erroneous belief that it then will not be paid back later is another common issue. Unfortunately this trick won’t work. Depreciation must be paid back whether or not it was claimed properly, so it makes no sense not to claim it. To understand the consequences, it’s easiest to look at an example:
John purchases a home for $240,000 to rent, $200k of which is attributed to the home value and not the land. In 10 years, he decides to sell the property when the home has increased in value to $350,000. Upon selling the home, John owes capital gains on the $110,000 of appreciation, AND has to pay an additional 25% on about $73,000 of depreciation (rounded up for simplification:(200k/27.5)*10)).
The planning can get a little tricky for real estate investors. Since gains on real estate assets aren’t as easy to control as they may be with stocks, there’s a tendency for gains to come in large lump-sums. It has the potential to push a tax-payer’s income into higher tax brackets and trigger additional tax layers, including an extra 3.8% for net investment tax, alternative minimum tax, or even a higher capital gains rate of 20%. While there are strategies to defer these gains, such as a 1035 exchange, it’s important to keep good records of improvements, depreciation, and expenses so you can make an educated decision on what to do with property down the road.