The Tax Benefits of Investing in Residential Real Estate

Whenever I discuss the tax benefits of investing in real estate, I start with this disclaimer: I am not a tax professional and I am not giving advice here. My goal is to provide ideas for you to discuss with your tax professional.

If you’re looking for a long-term investment, real estate is a great option. Do you have small children who may go to college someday? Purchase an investment property now and in 18 years, that property may go a long way toward paying for your child’s higher education.

A huge part of the tax benefit of investing in real estate is the ability to write off depreciation. Depreciation is the reduction in the value of an asset with the passage of time. So in real estate, it’s the ability to deduct a portion of the value of the improvements on a property. In real estate, “improvements” refer to how you’ve improved the bare land, things like structures, wells, and other additions nature did not provide.

Although the tax code changes periodically, right now the government allows you to depreciate improvements on a residential real estate property over the course of 27.5 years. This is straight-line depreciation, which means you deduct the same amount each year.

Depreciation shows up on tax returns as though it’s an expense you paid that year, even though you didn’t actually pay that money to anyone. Here’s how it works.

Let’s say you bought a duplex for $400,000 and 75 percent (or $300,000) of that value is attributed to improvements. Divide $300,000 by 27.5 years and you’ll see the annual depreciation is $10,900. If you have a break-even cash flow, meaning your rent covers expenses like fees, maintenance costs, and loan payments, then that depreciation is saving you anywhere from $3,500 to $5,000 a year in state and federal taxes. Unless you are a real estate professional, you are limited to rental losses of $25,000 per year.

Looking at the long-term benefits, let’s say you purchased the duplex with a down payment of $100,000. You have a break-even cash flow and a 3.5 – 5 percent after-tax return (the amount you saved by taking depreciation). This is in addition to the appreciation of the property value (if any). Although no one can guarantee future real estate values, the last five years have seen significant increases and the last 50 years have seen an average annual increase of more than 5 percent.

When it comes time to sell this little jewel, remember the reason for buying it was to send your kid to college. Eighteen years from now, let’s imagine you sell the duplex for $962,647—a 5 percent annual increase in value. During the 18 years you held the property, you realized $196,200 worth of depreciation. On that, you’ll pay 25-35 percent in recapture taxes (the government likes to recapture the depreciation). So, between brokerage fees and closing costs, your total costs are $62,647. Your net proceeds are therefore $900,000. (All of this is at today’s tax rates, so the numbers are estimates, of course.)

Unfortunately, we’re not quite done. Now we pay a capital gains tax on profit, which runs about $150,000 plus the recapture of $65,000. Also, you have to pay back the original $300,000 you borrowed to purchase the property. This will leave you with an after-tax amount of $385,000. Remember, you put $100,000 down, so that makes your profit $285,000 (plus the annual tax savings from depreciation of $3,500-5,000 each year for the past 18 years).

This is a conservative estimate, as it assumes you never raised the rent. It also assumes an appreciation of 5 percent. Earning $285,000 on a $100,000 investment over 18 years amounts to an annual compounded interest rate of 7.78 percent after taxes (or a pre-tax rate of 12 percent), and that doesn’t include the annual depreciation benefits.

All investing includes risk, but historically, real estate has been a good bet.

If you have questions about real estate or property management, please contact me at or call (707) 462-4000. If you’d like to read previous articles, visit my blog at Dick Selzer is a real estate broker who has been in the business for more than 40 years.

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