Hi, this is Scott Asbell. Zach asked me to write this chapter on tax advantages and loopholes because I was a Certified Public Accountant (CPA) for 22 years, have owned many investment properties, and have taught people for years how to take advantage of tax benefits with rental properties. As soon as I say the words "Internal Revenue Service (IRS)" or "taxes," I know that some of you are already starting to zone out and are thinking about skipping this chapter. That is okay-you can skip this chapter if you have a great tax advisor and you do not care about the details.
Just take two minutes to read the Simplified Overview so you are familiar with the principles. Before we start, I want to say that the best expert for your unique situation will be a local tax professional. Tax laws change over time, and local or state regulations may complicate matters. Even though the information in this book, and specifically this chapter, is current at the time of publication, tax laws change over time, and some of this information may be outdated by the time you read this book.
You want to do everything correctly, so be sure you are working with a reputable tax professional who can verify current tax laws and practices for your specific situation. Simplified Overview Here is a quick overview of the most important points in this chapter that you want to understand: Depreciation: Depreciation is a tool that allows you to take a tax deduction each year as your property ages. This helps to offset the tax you would normally pay on the rental income you receive. Rental Losses: Rental losses are always classified as "passive losses" for tax purposes and can only be used to offset passive income with two exceptions: You or your spouse qualify as a real estate professional, or You meet the Internal Revenue Code (IRC) income qualifications, which allows you to offset your other income.
Recapture: Recapture is the IRS's attempt to recoup (at the time you sell the property) the tax benefits you obtained from depreciation. Recapture can be deferred or avoided by Not selling the property and instead converting the entire property into a rental when you move, Conducting a 1031 Exchange, or Passing the property on to your heirs with a step-up in basis. A sale of the property will trigger recapture, so the trick is to find a way around selling it. 1031 Exchange-A 1031 Exchange is when you roll an existing investment property into another investment property and, in the process, defer the capital gains and recapture tax associated with the current property. Step-up in Basis: When you die, your heirs inherit your real estate with a tax basis of the current value of the property.
This washes out any capital gains or recapture that would have been due to the IRS if you had sold the property. No one ever pays the tax. This is how generational wealth is created and protected. Primary Residence Capital Gains Exclusion: Internal Revenue Code (IRC) Section 121 allows an exclusion of capital gains on the sale of a primary residence up to $500,000 for those who file as Married Filing Jointly (MFJ) or up to $250,000 for those who file as Single.
This allows you to sell an owner-occupied primary residence and not be taxed on what may be all, or at least a large portion, of the gain from the sale. As the owner of a home with an ADU, this exclusion works in your favor if both the owner-occupied and the rental portions of your home could be used as a single residence (without modification). In that case, the capital gain attributable to the ADU gets rolled into the owner-occupied portion and is not subject to capital gains tax under the above-noted limits. For those of you who just wanted the simplified overview, you can now skip to the next chapter.
For those of you who want to take a deeper dive, let's look at each of these tax advantages and loopholes in more detail.
Depreciation
Depreciation is a leading tax advantage of owning investment real estate and is a much simpler concept than you may have thought. When you purchase a property that is fully or partially used for investment purposes, it degrades, or depreciates-through use, wear and tear, weathering, etc. You do not value a vehicle that is ten years old the same way you value a current-year model; the same goes for real estate. Depreciation is a tax deduction you get to take on your rental property that can lower the amount of tax you pay to the IRS each year.
In a nutshell, you are allowed to take a tax deduction over time of the asset purchase price less the value of the land. While several different depreciation methods exist, the appropriate depreciation strategy for you will depend on the type of property you own and how old it is. Consult your tax advisor to determine the appropriate depreciation strategy for your specific situation. The most common method used is straight-line depreciation, which steadily depreciates the property over a specific number of years.
The number of years you are allowed to write off or depreciate your property is called the property's "useful life" and is determined by the IRC. The IRC has defined the useful life of residential rental property placed into service after December 31, 1986, to be 27.5 years. That means for every full year you own a residential rental property, you could depreciate it by 3.636% (100 divided by 27.5) until the book value of the asset is eventually nothing more than the value of the land (the portion that cannot be depreciated). This depreciation expense becomes an offset to your rental income (and possibly other income), which then lowers your taxable income and the amount of tax you pay to the IRS.
Let's look at an example. Before starting the calculation, you must determine the value of the land because that portion of your purchase price is not depreciable and must be subtracted; it cannot be written off or deducted. You can find the value of the land in the appraisal. If you did not have an appraisal, you will need to use some other reliable source, such as county records or a real estate agent's estimate.
If you paid $500,000 for an investment property and the land was worth $87,500, you would be able to depreciate $412,500 ($500,000-$87,500) over 27.5 years. The depreciation expense would amount to $15,000 per year. Assuming you were in a 33% tax bracket, this $15,000 depreciation expense could save you $5,000 in actual tax owed to the IRS each year. With a house-hack, you mentally split the property into two pieces: the piece you live in that is owner-occupied and the other piece that is rented.
Depreciation rules will not allow you to depreciate any of the owner-occupied portions of the property, but the portion of the home that is rented is eligible to be depreciated. Most people simply calculate the square footage that is rented as a percentage of the total and then apply the depreciation rules to that percentage of the home. Some would argue that a 1,000-square-foot basement is not valued the same as the 1,000-square-foot above-grade portion of the home and come up with some other method for determining the amount to be depreciated. Consult your tax advisor to determine the best method for your specific situation.
Improvements Improvements made to a rental property may be written off or deducted in the year incurred if they are small enough to be classified as repairs (consult your tax advisor for specific thresholds). If the expense is larger than what is considered normal repairs and maintenance, you may not be allowed to deduct the entire cost from your taxes that year. You may be required to classify the expense as capital improvements, which are depreciated over their estimated useful life. This means when you remodel a bathroom, replace a furnace, or replace a roof, those items may also become a tax deduction spread out over a time period determined by the IRC.
The IRC classifies improvements as anything that makes a property better than it previously was. It is important to keep detailed records of any improvements you make. You can deduct or capitalize home improvements and repairs that benefit the rented portion of your home.
Rental Losses
Regardless of your income, tax law always allows you to use depreciation to offset your rental income on your taxes. For example, let's say you own real estate that has rental income and depreciation expense. The depreciation expense can be used to offset your rental income, whether you make $1 million or $10,000 that year. Some investors confuse the laws and think that higher-income earners have limited depreciation advantages, but this is not necessarily true.
There is never a limitation on how much depreciation you can use to offset rental income. Where the limitations start to enter the picture is when someone wants to offset other income with depreciation expense that is more than rental income. If you own multiple properties, you can take the loss generated by depreciation from one property and apply it against the income of another. Annual income or losses from each property are typically combined (netted) to determine if you have income or loss from all your rental activities for the year.
In most cases, you report your rental income and deductible expenses on Schedule E of your personal tax return (Form 1040). Often, you may have a loss for tax purposes even if your rental income exceeds your operating expenses. This is because depreciation (a non-cash expense) is a large amount and changes what would be positive income into a loss for tax purposes. Rental losses are always classified as "passive losses" for tax purposes.
Passive losses can only be used to offset passive income-income you earn from rental real estate or other passive activities. Without passive income, your rental losses become suspended, and you do not deduct them until you have sufficient passive income in a future year or you sell the property. Exceptions to Passive Loss Rules There are only two exceptions to the passive loss rules: You or your spouse qualify as a real estate professional, or Your income is small enough that you can use the $25,000 annual rental loss allowance. IRC rules state that a real estate professional is someone who spends more than 50% of his or her time in real property trades or businesses and more than 750 documented hours during the year in active participation with those trades or businesses.
Real estate professionals get to treat rental real estate activities in which they materially participate as nonpassive income/loss. If you qualify, this would allow you to deduct rental real estate losses from other nonpassive income. If you do not qualify as a real estate professional, you can still use up to $25,000 of your excess rental losses to offset your other income if your modified adjusted gross income (AGI) is under $100,000 and if you "actively participate." Active participation means you are involved in meaningful management decisions regarding the property and have more than a 10% ownership interest in the property. If your income is between $100,000 and $150,000, then you can still use your real estate losses to offset your other income, but the amount you can use may be limited as the allowance is phased out as your income approaches $150,000.
Once your income is over $150,000, you cannot use the excess losses to offset your other income; instead, those losses can offset future rental income. If you make more than $150,000 a year, there are still ways to take advantage of depreciation, and your tax advisor will give you guidance on how to do that to maximize profits on your investment. Recapture Even if you are among the most prepared property owners, you can be surprised by depreciation recapture tax (a type of capital gains tax that works to recoup the deductions you received from depreciation write-offs) after you make a profit from a rental property sale. If you sell a rental property for a profit and have taken depreciation deductions, your property is subject to a depreciation recapture tax.
The amount of the tax is based on your capital gain from the rental property sale. The gain can be calculated by subtracting the home's depreciated value from its sales value. The portion of the gain attributable to depreciation is taxed at the current depreciation recapture tax rate, which is your ordinary income tax rate, up to a maximum of 25%. The portion of the gain attributable to appreciation is taxed at long-term capital gains rates (if the property was held longer than one year), which are currently at 0%, 15%, or 20% depending on your income.
The IRS allows you to determine whether to expense depreciation each year. If you decide not to take the depreciation, they do not allow you to pick up that skipped portion in some future year-you just lose the option of ever depreciating that portion. Some people may be tempted to opt-out of the depreciation tax deduction upfront to avoid paying depreciation recapture tax in the future. However, the IRS charges 25% of your potential deductions regardless of whether you took the deduction.
So, you may as well claim the deduction each year and plan accordingly, which can involve paying the total recapture tax or finding strategies to avoid it. This is an area that merits careful tax planning and strategizing with your tax advisor. If you want to avoid recapture tax, you will want to do one of the following: Not sell the property and instead convert the entire property into a rental when you move, Conduct a 1031 Exchange, or Pass on the property to your heirs with a step-up in basis. Let's consider each of these options.
Convert the Entire Property into a Rental One way to avoid recapture would be to move on to another primary residence and convert the previous home into a rental. This would basically kick the can down the road and defer any possible gain and recapture by avoiding a sale.
1031 Exchange
Down the road, if you choose to sell your investment property, you have a couple of options. You could sell it, take the money, and be taxed on the gain. The gain would be the amount of profit you realized after considering the sales price minus the basis (basis = original purchase price + improvements, depreciation). This amount would be subject to capital gains and recapture tax.
Another option is to do a 1031 Exchange, where the IRS allows you to exchange "like-kind" properties for each other-one investment property for another. This essentially allows you to roll the property you sell into a new property and defer the gain and recapture you would have realized so that it is not currently taxable. A "combined use property" (like a house that is used as owner-occupied and investment at the same time) can be exchanged into a new property that is 100% investment or another house that is combined use. Step-up in Basis One of my favorite tax benefits of real estate is what we call "step-up in basis." This is the long-game approach to owning real estate and is a brilliant way to pass wealth generationally within a family.
If you, as the owner, eventually sell an investment property at a profit (your sales price minus your basis [basis = original purchase price + improvements, depreciation]), you could potentially owe a lot of tax. But if you allow that property to pass to your heirs after your death, then their tax basis in that property becomes the fair market value (FMV) of the property on your date of death instead of your basis (your original purchase price + improvements, depreciation). Since the gain is determined by subtracting the basis from the sales price, the higher the basis is, the lower the gain will be and the less tax you will owe. Your basis is likely to be much lower than the current fair market value of your property, especially if you purchased it years ago and have depreciated a lot of the value over those years.
Determining the gain based on the current fair market value of the property instead of your basis will almost always lead to less tax owed to the IRS. For example, let's say you purchased a property for $400,000 and held it for thirty years. During the time you held the property, you depreciated $300,000 of the original cost (everything except for the $100,000 value of the land). Now, thirty years later, the property is worth $1 Million.
If you were to sell the property with the intention of giving the money to your children, you would experience a taxable gain of $900,000 ($600,000 [the difference between your current sales price of $1 Million and the original purchase price of $400,000], and $300,000 [the difference between your original purchase price of $400,000 and the $100,000 land portion that was never depreciated]). Imagine the tax that could be due on a $900,000 taxable gain-part of which would be taxed at current capital gain tax rates and the other part at recaptured depreciation rates. Let's just keep it simple and say that you are subject to a 20% capital gains tax rate. So, the $600,000 would be taxed at 20% ($600,000 X .20 = $120,000), and the recaptured depreciation would be taxed at 25% ($300,000 X .25 = $75,000), leading to taxes owed of $195,000.
Under this scenario, you would only net $805,000 to give your children after paying the tax owed to the IRS. Now, consider that instead, you do not sell the property, and you allow it to pass to your children through the normal process of inheritance. Your children would inherit the property, and their basis in the property would be $1 Million (assuming that is the property's value on the date of your death), and they could immediately sell it for $1 Million and experience no gain with no capital gains or recapture tax owed to the IRS, saving them $195,000. Of course, estate tax issues need to be considered and planned for accordingly, but you can see that there are ways to avoid tax and keep the money in your family.
We recommend that you work with your tax advisor and your estate planning attorney to devise the best strategy for you and your family, depending on your specific circumstances. The Primary Residence Capital Gains Exclusion If your house-hack was your primary residence for a qualifying period, you could potentially avoid capital gains tax with a Section 121 exclusion. Typically, capital gains tax can be avoided on the sale of a primary residence up to $500,000 for a joint return with a spouse, or up to $250,000 for an individual, if you have lived in the home for at least two of the past five years. If both the owner-occupied portion and the rental portion of your residence could be used as a single residence (without modification), then you can exclude all the gain (up to the limits) except for the recapture.
An example of this would be a basement apartment with stairs leading to it from inside your residence, making it so you do not have to leave the owner-occupied portion of your home to get into the rented portion of your home. Properties with ADUs like this are still required to have their own entrance and exit separate from the staircase that internally connects the two portions of the residence. Access to the ADU cannot only be through the primary dwelling. If the ADU or rental portion of your home is not accessible from your residence, then you cannot exclude the gain attributed to the rental portion of the home.
It does not fall under this umbrella of protection and is subject to capital gains tax and recapture. An example of this would be an apartment above a detached garage or a stand-alone ADU built on your property that is detached from your residence. For example, let's say you purchased a home with an ADU, which is 50% of the home, for $400,000, and the land was worth $100,000. After a few years, you decide to sell the property for $500,000.
During the time you owned it, you depreciated $50,000 on the rental portion of the home. You would have a $150,000 ($500,000 minus $350,000) capital gain, of which $50,000 is attributable to the owner-occupied portion of the home, $50,000 is attributable to the rental portion of the home (assuming the percentage of owner-occupied and rental space was split equally), and $50,000 is attributable to the depreciation taken on the rental portion of the home. If your ADU was part of a single residence, of the $150,000 capital gain, $100,000 could qualify as tax-free through an IRC Section 121 exclusion, and the $50,000 of depreciation would still be subject to recapture tax. On the other hand, if your ADU was separate from your residence, you would have $50,000 of excludable gain from the owner-occupied portion of your home, $50,000 of taxable capital gain on the ADU portion, and $50,000 of depreciation subject to recapture tax.
In this example, having the ADU that is accessible from your residence could result in up to $10,000 in tax savings (the $50,000 of taxable gain on the ADU portion times 20% capital gains tax) because that portion of the gain would fall under the exclusion. Final Thoughts As a real estate investor, I can tell you that the beautiful thing about properties with any type of rental aspect tied to them is the tax angle. Depreciation is a legitimate offset to income that lowers the amount of tax you pay. The 1031 Exchange is a legitimate way to trade properties as your situation changes over time and continue to defer taxes.
Step-up in basis is my favorite hack of all (be it principal residences or investment properties) because it allows wealth to pass from one generation to the next without the IRS becoming part of your family and demanding their piece of the pie. The Primary Residence Capital Gain Exclusion is also a fantastic way to strategically take ground and hold it every time you sell a principal residence, which makes owning a home the foundational cornerstone for anyone wanting to build wealth and prosperity. I understand that it may not make sense to buy and hold every piece of real estate you acquire. I have not kept all of mine, and there are good reasons why you may sell a property along the way.
Yet, imagine for a moment purchasing a property, depreciating it fully, conducting a 1031 Exchange to trade it into a more expensive property that can then start a new series of depreciation, collecting rents for decades, and eventually passing the property to your heirs tax-free through a step-up in basis. That is the beauty of real estate and what it can do for you. By being familiar with the basics of these tax-saving principles and strategies, you are now better equipped to own real estate investments. You will now understand what your mortgage, tax, and legal advisors are referring to when you hear them use these terms in regard to avoiding, deferring, or eliminating taxes.
All these strategies can work in unison to your benefit with the guidance of trusted mortgage, tax, and legal advisors. Just find the right team and let them guide and protect you.
