By Justin Fundalinski, MBA | July 20, 2017
With the real estate market showing strong growth year over year in Northern Colorado we have seen many clients purchasing rental properties to hopefully benefit from higher rents and rapid capital appreciation. This month’s article is not going to dig into the viability of such investing; rather it will overlay a perspective on how rental income, depreciation, and capital appreciation of rental properties affect one’s taxes now and later.
Rental Income and Expense Deductions
From the many tax returns I have reviewed or prepared there is a common theme. That is, because large depreciation expenses can be deducted against the income generated from rents, a hefty portion – if not all – of the income generated appears to be received tax free (and quite possibly creates a loss). Of course, it is narrow minded to believe that you will never be taxed on this income and understanding the effects of how this effective tax deferral works may have you second guessing the alleged benefit of these so called “tax free rents.”
How Depreciation Works
When you write off depreciation against your income you are essentially taking a write off at whatever your marginal tax rate is that year. What you are also doing is lowering your basis in the property which will later be taxed at a special capital gains rate (not the normal 0%, 15%, or 20% rates) when you sell the property. This special capital gains rate is called “unrecaptured section 1250 gains” and its rate is 25%. So, what this essentially means is that any depreciation deduction that you write off on the building structure you are locking in a future tax rate of 25%.
I would venture to say that an appropriate thought process on this tax deferral is similar to how we think about Traditional IRA or 401(k) contributions (sans the tax deferred growth factor). If you are going to take a deduction from your income now to save on taxes the goal should be to realize the tax hit at a lower rate in the future than what it could be taxed at currently. With the special capital gains rate on the depreciated portion of the structure at 25% that may be a difficult hurdle to overcome. However, depending on other income that you are generating from employment or other sources this may be no hurdle at all.
On a side note, I can feel that a savvy reader may be saying, “Well I don’t have to take the depreciation deduction and I can realize the income now at my current lower tax rate.” Unfortunately that thinking is flawed. The IRS assumes that the basis in a rental property is reduced at the maximum allowable depreciation amount; not at the rate at which you choose to depreciate.
On a secondary side note, for any rental properties that were depreciated at an accelerated rate (that is purchased before 1986 and did not use straight line depreciation) there is a different set of “recapture rules.” It gets ugly to explain and does not apply to most people now that we are in 2017, but if you do have questions let me know.
On a tertiary side note, I will say that due to lending opportunities in the real estate market, I could make compelling arguments that using the rents to cover lending expenses solely for the sake of taking advantage of capital appreciation (and ignoring the income aspect) could be a viable strategy. However, that is not the topic of this article and warrants much more discussion around the pros and cons (so please to don’t take any aspect of this article as a recommendation for or against rental properties).
What about appreciation?
Capital appreciation (or any increase in value that you have above and beyond the original purchase price) is likely what most people are seeking right now when they purchase rental properties. The taxation on capital appreciation is just like any other capital gain. You will be taxed at normal 0%, 15%, or 20% capital gains rates depending on what your total adjusted gross income is. In most cases that I have seen, some of the gain is taxed at 0%, the majority of the gain is taxed at the 15% rate, and if it is a very large gain or there is other significant income factoring into the equation some of the gain is taxed at 20%. Keep in mind that this will be different for everybody and may significantly vary.