Tax Efficiency of Rental Real Estate

Many prospective rental property owners like the appeal of generating passive rental income, but worry about the associated tax burden, both financially (“Will my rental income drown me in taxes?”) and logistically (“How can I take care of all the necessary filing?”)

Today we unpack the finances behind a typical residential property. We will use actual numbers to explain why real estate is widely considered as a tax shelter, and how zero taxes on rental income during property ownership can be achieved with relatively little work. For the most advanced investors, we will provide some advanced pointers as well.

Disclaimer: The information provided in this article is for informational purposes only. We are not financial or tax advisors. You should consult with a professional in the relevant field.

Taxation Basics: A Year of Rental Income

Using a specific example, let’s break down a typical year for a rental property. This property is a nice single family located in a “Class A” area1.
Example House in Denver Metro Area

Let’s use the default estimated projections for this property for one year of operations:

Income Expenses
Rent $36,000 Property Tax $5,000
Vacancy (5%) -$1,800 Insurance $2,500
Management (10%) -$3,420 Repairs $5,000
Mortgage Interest (3.375%) $14,425
Revenue $30,780 Operating Expenses $26,675
Appreciation (3%) $17,250

On the revenue side, after we budget for some vacancy and property management charges, we will get $30,780 in net rent, and we estimate to pay $26,675 in total expenses, including property taxes, insurance, maintenance, and interest. The Net Income for this property is only $4,105.

This may be slightly different from what your actual investment return is for 2 reasons:

  1. Any property appreciation is not considered “income” until you sell the property. Even at 3% appreciation a year (a very conservative estimate by historical standards), the $17,250 of appreciation a year on this property will not be taxable until you sell it.
  2. Each monthly mortgage payment contains an “interest” portion and a “principal” portion (in this example, $14,425 interest + $6,332 estimated principal). The principal payment reduces what you owe to the bank over time. If you sell the house 30 years later, you no longer owe the bank any money, and can retain the entire sales proceed due to all the principal payments in the 30 years, but these principal payments are not considered income nor expense.

Structural Depreciation as a Tax Shelter

In the above example, you may expect your taxable income to be $4,105. However, the US tax code is very friendly to real estate owners due to the concept of Structural Depreciation: even though the actual market value of most properties appreciates over time, the IRS lets you deduct a certain amount for the “wear and tear” of the structure every year. For residential real estate, IRS considers the “lifespan” of the structure to be 27.5 years, you may deduct 1/27.5 of the structural value each year.

In our example, the house’s property tax statement from the county may list $100,000 of land value and $450,000 of structure value. Each year, we may deduct 1/27.5 of the structure, aka $16,364. Now your net income is negative -$12,259.

Revenue $30,780 Operating Expenses $26,675
Structural Depreciation $16,364
Net Income (Loss) -$12,259

The $16,364 depreciation isn’t an actual out-of-pocket expense. It’s a “paper loss” due to how US tax code. Most rental properties in the US, especially those with mortgages, will often report a tax loss due to this depreciation deduction, and their owners typically do not pay any taxes on rental income for years.

Claiming this depreciation is very simple. You already receive property tax statements from the county, and basic tax software (such as TurboTax) can do the calculations - you just need to put in the structure value from the county’s statement. Of course, CPAs can easily handle this too.

The Tax Man Comes… At Sales Time

While our rental owners might be enjoying tax-free income now, it’s essential to remember that Uncle Sam hasn’t forgotten about them. When the property is sold, two main tax implications come into play:

  1. Capital Gains: If you sell your property for more than what you bought it for, you’ll owe taxes on the profit.
  2. Depreciation Recapture: Depreciation reduces the “tax basis” of your property, so you will owe more gains taxes than just the net increase in sales price.

In our example, suppose we bought the property at $575,000 and sell the property for $875,000 after 5 years, not only do you have $300,000 of capital gains, but you have $81,820 of gains from depreciation recapture.

Purchase Price $575,000 Sales Price $875,000
Depreciation (5 Years) -$81,820
Net Cost Basis $493,180Taxable Gain $381,820

In essence, while the rental income is effectively tax-free during your ownership, at sales, everything becomes taxable again.

This doesn’t mean you’ll necessarily pay a hefty tax. Many of our clients are high-income professionals who have low-income years (joining a startup with a lower salary, taking a “gap year” to travel, having large tax loss when the market is down), and they can often align the sale of their property with these low-income periods.

This is why direct control of the asset matters. An Investor in a private real estate fund/syndication generally gives up control of the timing of the sale, but directly holding the real estate asset allows you to plan the sale of your assets at the most opportune time.

Advanced Real Estate Tax Planning

“Paying zero taxes during ownership” is already a desirable tax proposition for any investors who are busy working professionals. However, for the more adventurous and advanced investors, here are some pointers to advanced topics that can save hundreds of thousands of taxes. We may discuss more of these topics in depth in the future.

  • 1031 Exchanges: If an investor continues to invest in real estate after selling her previous property, she may generally defer any taxes due on the sale via 1031 exchange. For long-term investors, the capital gains and depreciation recapture may be deferred indefinitely. When she passes away and gives the property to her children, a large amount of deferred taxes can be permanently extinguished.
  • Real Estate Professional Status: If an investor is professionally working in real estate, the “paper loss” we discussed in the previous example (-$12,259) becomes deductible against her other income (such as salary from a day job). Most people who have day jobs will not qualify as “Real Estate Professionals”, but a couple filing a joint return may designate one non-working spouse to work as a real estate professional. If the couple has a large portfolio of rental properties, they can often end up paying zero taxes for their salaried day job as well.

In general, when picking real estate investments, the projected returns of the investment should trump tax consideration alone (“Don’t let the tax tail wag the investment dog”). That said, the large tax benefits can make the investment extra attractive for most high-income earners. When working with our clients, we can take their tax situation into account when helping select investment properties.

  1. 1.For more details of “Class A/B/C”, see Classification of Neighborhoods