The Tax Advantages of Buying a HomeYou’ve heard again and again how buying a home is the best tax break around. Maybe you’ve even been called a chump for renting. After all, paying $1,200 a month for your mortgage is really the equivalent of paying $900 a month in rent. But how does that work exactly? Here’s the deal: Mortgage interest (including points) and real estate taxes are tax deductible. That doesn’t sound very sexy, but it adds up. Since most of what you pay for your mortgage in the first years is interest, on a $1,200 mortgage payment you get to deduct about $1,080 a month. That reduces your taxable income by about $13,000 a year. If you’re in the 28% tax bracket, that deduction is worth about $300 a month. To see the benefit, you can either wait for a big payout after you file your incometax return, or adjust what is withheld from your paycheck each month. Claim additional allowances on your W4 form and your paycheck will jump immediately. You’ll have to do the worksheet on the back of the W4 form to figure out how many additional allowances you can claim. But using the above example, you could take two or three more

CASH FLOW, LEVERAGE, AND TAX BENEFITS FOR INVESTMENT REAL ESTATE
CASH FLOW
CAP (capitalization) Rate is also known as the performance of a property. Once it is determined that you are leveraging, then the cost of money must be determined (mortgage interest rate). As long as the cap rate is higher than the cost of money it is a good investment. For example, if a property performs at 8% and your cost of money is 6.5%. You will make 8% on your money and 1.5% of other people’s money. A $100,000 property with a 20% investment. The $20,000 investment will yield 8% or $1,600 and the $80,000 will collect the difference of 1.5% which is $1,200 for a total cash on cash total return of $2,800, making it a 14% return by Real Estate.
Example with basic numbers:
$100,000 Purchase price
$100,000 Investment
$ 12,000 Gross Income
$ 2,000 Expenses (we are going to assume all expenses including property taxes and insurance)
$ 10,000 Profit
Profit divided by investment $10,000/$100,000 = 10%
LEVERAGE
It is said that with a lever large enough one can lift the earth. Based on the above example property, we now know that the property performs at a 10% rate of return. Instead of paying cash for the property we will want to leverage our money. We invest $20,000 and borrow $80,000. Although the $80,000 is a debt by itself, in a leverage situation it is a powerful tool. The $80,000 is borrowed at 7%. Remembering that the property is performing at 10%. This is a 3% difference.
Where does that money go? Assuming that the price, income and expenses are the same as above.
$100,000 Purchase price
$ 20,000 Investment
$ 80,000 Borrowed
The $20,000 investment earns 10% or $2,000 (CAP Rate is based on cash).
The $80,000 borrowed at 7% has a yield spread of 3% (remembering that belongs to the investor).
$80,000 x 3% = $2,400 Giving a total of $4,400 return on investment, which equates to a
22% rate of return.
Because of leverage you may be able to do that 5 times with the same $100,000 investment ($20,000 investment to 5 properties) and generate a total of $22,000 per year.
TAX BENEFITS
Rental income is considered passive income and is taxed differently than earned income (W2/1099). It is not subject to self employment tax or FICA. If you are self employed, you pay all the FICA. If you have an employer, that employer pays half of your FICA. Self employment tax is a little over 15%. A s an employee you are paying it indirectly through costs to the employer, these costs are passed on to you in the form of a lower wage.
Now working on the assumption we leveraged our $100,000 and we are generating $22,000 per year (not counting any future rent increases). We just dodged 15% in taxes. Now we are left with income tax and this is where depreciation comes in. Residential property is depreciated over 27.5 years. To determine the depreciation we take 100 and divide by 27.5 and come up with 3.63%. Land is not depreciated–only the improvements are.
Maintenance is deducted and improvements are depreciated. So always talk to an accountant before making any major improvements. For instance, fixing a leak “may” be a maintenance item and replacing the roof “may” be an improvement.
Now we will take one property and work out the math. Remembering that land is not depreciable we deduct 20% for the land and take 80% of the acquisition cost (may include purchase price and immediate capital improvements). In our case that equals $80,000. Depreciated at 3.63% equals $2,904 deduction on our income tax. Leaving us with a $1,500 taxable event, if you are in the 20% bracket that equals $300 dollars. Now let’s multiply that by the 5 properties.
$500,000 properties are put into performance
$400,000 of depreciable property
X 3.63% $ 14,520 in deductions
$22,000 in income and having only a $5,480 taxable event. $5,480 x 20% equals $1,096 dollars in tax owed to the federal government. (not including state income tax).
Now let’s look at 30 years from now. We bought 5 properties for $100,000 each. Today they are worth $500,000 each. $2,500,000 nets yearly rents of $50,000 x 5.5 equals $275,000, with no mortgage payment. This serious money, but we are now faced with a $275,000 taxable event. This means you will now be well into a 30% bracket. You will have a tax liability of $82,500. But you will still have a very good income.
What if you sold the properties? You have depreciated the properties down so your capital gain would be $2,500,000. Which is not as bad as income tax. Long term capital gain is 15%. Or $375,000, netting $2,125,000.
But there are things to help to avoid paying some of these taxes in both scenarios. Let’s say you have no desire to sell. You can refinance the property.
For our exercise we will do a conservative 70% loan to value. $2,500,000 x 70% equals $1,750,000. That money is tax free. Why? Because only income is taxable, no borrowed money. So now you have the $1,750,000 cold hard cash in hand and you can do anything you want with it. Also you still have 30% of your property performing. If we carry the same numbers of 10% performance and 7% cost of money, we are still collecting.
$ 2,500,000
$ 750,000 Equity position or cash
$ 1,750,000 Mortgage
$ 750,000 times 10% = 75,000
$1,750,000 times a 3% yield spread = $52,500
$ 127,500 per year income that is taxable
1031 Exchange
Another option is to trade. This has a few more advantages. When traded properly through a 1031 Tax Deferred Exchange the capital gains tax is deferred and not owed. There are rules to that event, such as you must identify a replacement property within 45 days and close the property out within 180 days, including the 45 day identification period. It must be for equal or greater value. If it is less, then the difference is taxable. Also it must be like properties, such as two duplexes for an apartment complex.
As an example, we sell our 5 properties totaling $2,500,000 in a 1031 Tax Exchange. We then go out and identify a replacement property. Then in the time frames necessary we close on the replacement. The replacement property performs at 10% giving an income of $250,000. We now have depreciation based on today’s acquisition cost. $2,500,000 x 80% which equals $2,000,000. Meaning you would multiply the $2,000,000 by 3.63% which equals $72,600 in deductions.
Then you would refinance an amount of 70% loan to value which equals $1,750,000. You would then have that amount tax free. Let’s assume we borrowing at 7% again.
$ 2,500,000 Acquisition cost
$ 750,000 Equity position or cash
$ 1,750,000 Mortgage refinanced
$ 750,000 times 10% = 75,000
$ 1,750,000 times a 3% yield spread = $52,500
$ 127,500 per year income
So now we have to deal with that for income tax reasons. $127,500 minus the $72,600 in depreciation equals a $54,900 taxable event.