MIREALTOR® Online June 2014 | Page 19

Now here’s the good news: for tax purposes, these benefits can be sheltered by depreciation. Depreciation is a “non-cash” deduction (it’s also known as cost recovery). The tax rules allow the owner of rental property to depreciate their cost over a number of years. The specific number of years depends on how the cost is allocated. It’s important to allocate the cost of the property into categories that include: land, building, personal property and land improvements. Many people lose money by only dividing their cost into land and building. Each category is depreciated over a different number of years: LAND Not depreciable BUILDING 27.5 years for a residential rental building 39 years for a non-residential rental building PERSONAL PROPERTY 5 years in a residential rental property (appliances, carpet, furniture, etc.) LAND IMPROVEMENTS 15 years (parking lot, landscaping, fence, etc.) Returning to the example, let’s assume your total depreciation for the year is $5,000. Every dollar of depreciation shelters a dollar of income, starting with income from the property. So, the depreciation first shelters the $1,000 cash flow plus the $500 principal reduction. They’re completely tax sheltered. And you’ve still got $3,500 of unused depreciation left over. This leftover depreciation is reported as a “loss” for income tax purposes. For most people this loss can be used to shelter income from their job or other sources, resulting in tax savings. That’s the third benefit. The tax savings are in addition to the tax-sheltered cash flow and principal reduction. Not bad! Why did I say most people can use the leftover depreciation to shelter their income? Well, as you know, tax law is never simple and there are rules called “passive loss rules” which govern when a real estate tax loss can be applied. These rules are beyond the scope of this article so be sure to ask your good tax manager how your unique situation is affecte d. Be extra sure to ask about the special “exception for real estate professionals.” You’ll love it! 4. APPRECIATION: The fourth financial benefit of owning investment real estate is appreciation (or increase in value). We all know someone who owns a property that’s worth a lot more than they paid for it years ago. It didn’t happen overnight, but over the years. The combination of these four benefits can be a powerful, powerful wealth-building tool! HELPING SELLERS: RETURN ON EQUITY Once you’re comfortable with how the four benefits affect investor buyers you can also use these same concepts to work with investor sellers. One approach is to show a property owner their “return on equity.” Consider the following. Assume an investor named Ben bought a rental house sixteen years ago. Ben invested $10,000 and borrowed the rest. He was smart and did the pre-purchase analysis. The cash flow, principal reduction and tax savings added up to net benefits of $1,400 that first year. By dividing the net benefits by the $10,000 investment Ben’s rate of return was 14% ($1,400 divided by $10,000). Not bad – plus, the property was appreciating. He’s an investment genius! But…fast forward sixteen years. Today, Ben’s cash flow and principal reduction are still positive. However, much of the depreciation has been used up over the years. There’s no longer enough depreciation to completely shelter the cash flow and principal reduction (let alone shelter income from other sources). WWW.MIREALTORS.COM 19