Is rental property a tax-wise investment?

Investing in rental real estate has long been considered a smart way to build equity in an appreciating asset while enjoying significant tax benefits. However, with every new piece of tax legislation, Congress seems to whittle away at the tax breaks for real estate investors.

Today, tax breaks alone no longer justify an investment in real estate. However, if the investment is economically sound, tax benefits can enhance your return.

The basic rules

To make investments in rental property pay off, you should analyze taxes and cash flow. Here's a simple example to illustrate the basic rules.

Assume the purchase of a single-family house for $125,000 of which $25,000 applies to the land and $100,000 to the building.

Depreciation of the cost of the building is a tax deduction even though depreciation is not paid out in cash every year. However, the deduction must be spread over 27.5 years. Divide the $100,000 cost of the building by 27.5 years. Your depreciation expense is $3,636 per year.

Assume a cash down payment of $30,000 and a mortgage loan of $95,000 for 25 years at 8%. The first year's payments would be $8,799 including about $7,555 of tax-deductible interest.

Suppose the property is rented for $12,000 a year, and operating expenses, such as property tax, insurance, and repairs, total $2,500.

To calculate the taxable income (or loss) from the property, you will subtract from the rental income of $12,000 the three types of expense: depreciation ($3,636), interest expense ($7,555), and operating expenses ($2,500). The result, for tax purposes, is a rental loss of $1,691.

The tax rules on a rental losses are different if you're a real estate professional. But if you're not a professional, here's how your rental loss could affect your income tax.

If you actively manage the property and your adjusted gross income does not exceed $100,000, the rental loss (up to a maximum of $25,000) could be deducted from other income such as salary, interest, and dividends.

Multiply the rental loss by your federal income tax rate. If you're in the 31% tax bracket, the federal tax avoided as a result of this deductible rental loss is $524.

Cash flow can now be calculated:
Rental income	$ + 12,000
Plus: Tax savings	+ 524
Less: Operating expenses	- 2,500
Less: Mortgage payments	- 8,799
	________
CASH FLOW	$ + 1,225
The investment produces a cash flow of $1,225 in the first year.

Your equity in the property would increase each year as the mortgage loan is paid down. Any increase in the value of the property during your years of ownership will increase your ultimate return.

Calculating the cash flow on a rental property investment when you're considering will help you decide whether the investment is a good one. You may want to avoid investments with a negative cash flow because you'll have to come up with additional money to cover operating costs and debt payments.

Capital gains

When you sell your rental property, the profit is a capital gain, taxable like any other capital asset under the tax law. But there's one additional complication: the portion of the gain that represents prior depreciation is subject to special tax rules.

If you sell at a loss, the loss is considered "ordinary", which means you can deduct the entire amount, rather than being limited by the $3,000 annual capital loss limitation.

Tax-free exchanges

If, instead of selling your property, you exchange it for "like-kind" property in a "tax-free" exchange, you can delay the tax until you sell the replacement property.

Your tax basis in the new property you receive in the exchange is the same as your old property, plus any "boot" paid (cash or additional mortgage you assumed) to acquire the new property.

In an exchange, matching two parties whose properties are suitable to each other is rare. Where the parties aren't happy with each other's properties, like-kind exchanges often expand from a two-party exchange to a three-cornered exchange.

In a three-cornered exchange, the buyer doesn't own suitable replacement property for the exchange. The seller identifies property he wants to receive, and the buyer then purchases the property and exchanges it with the seller.

Though exchanges require careful planning and professional assistance, they can result in significant savings.

The laws governing rental real estate are extensive and complex. Before you commit to a purchase, sale, or exchange, contact us for a complete tax analysis.