Real estate tax deductions for condos
Real estate tax deductions and how I use them
One of the main reasons real estate is so attractive as an asset class is its privileged tax treatment. Understanding the full implications of real estate taxes for both primary residences and income properties is a vital part of being a real estate investor. Now, since I am a condo owner I've approached this all from that perspective, but you could use most of this for single family homes as well.
Primary residences
The mortgage interest tax deduction is one of the most famous tax deductions in the entire tax code, and it has the potential to be an enormously powerful one too.
At its heart the deduction allows anyone to take the interest payments that they make on their mortgage (for primary and secondary homes) and deduct them from their top line income to reduce their tax bill. For instance, a homeowner that has a $2000/mo mortgage payment -split evenly between $1000 in interest and $1000 in principal- will rack up $12,000 in interest payments a year (12x$1000). If their tax rate is around 33%, that means that they will save around ($12,000 * .33)=$4000 on their taxes the following year.
This deduction is highly regressive: the more you make, the higher your tax rate, and the more it benefits you. If you have a second home, it benefits you even more! High earners, especially those nearer to the beginning of their careers, should take out as large a mortgage as they are comfortable with (and can safely afford) to take maximum advantage of the tax credit. There is a cap on the deduction, so keep that in mind.
The side benefit to a large mortgage (which is certainly a burden) is the leverage on the potential growth in the underlying value of the home. With 20% down, every 1% of value growth in the underlying property yields a 5% paper profit in the underlying home. Keep in mind, that’s about the average long run real estate growth rate, and that math only works out as a long run investment because the transfer costs are so high in real estate.
I am keeping this relatively simple in the interests of brevity, but it's important to note that people with home offices, and people who rent their home out will have reduced or different tax benefits with regard to mortgage interest. I'm sure there are plenty of other caveats I am missing as well, so consult an accountant... but you get the basic principle.
Depreciation and other tax benefits of rental properties
Alright, time for some brutal honesty. I am a finance blogger, but I never took accounting. The word depreciation sends chills down my spine. As I’ve covered previously, last year we purchased a condo and remodeled it with the intention of living in it permanently. When we moved for work, we had to switch plans and rent it out, which altered the tax situation a little bit because the condo is a business now instead of a home. We still get to deduct the interest on the mortgage, but as a standard business deduction against the income of the property. Along with that we can deduct real estate taxes, out of pocket expenses, and depreciation, which is the most valuable of these deductions.
I was a little afraid of calculating my condo depreciation but it's actually really simple. We can take depreciation on the value of the “structure and improvements” invested in the building itself. In other words, nearly everything except the value of the land can be depreciated. And YES, condos do have land value! The total “structure and improvements” value is generally whatever the purchase price is + any additional capital improvements made to the structure. Whatever you have borrowed against the home doesn't come into play.
A standard depreciation schedule is 27.5 years, and each year an equal amount of the total depreciation value is deducted. For instance, a $600k house with $100k land value and $50k in remodel costs has a total depreciable value of $550k ($600-$100+$50). Divide $550k by 27.5 and you get $20k in depreciation every year.
Of course, this is a deduction, so using the same 33% tax rate we arrive at an actual value of $6666 each year. Not too bad.
One huge caveat to this: once you sell, and log a capital gain, the depreciation is owed back to Uncle Sam. I am not a tax attorney so I’m not going to go over this. I will say that it’s certainly another very good reason to hold real estate for the long term; if you never sell, it's never a consideration.
Because of the other deductions (like expenses and real estate taxes), it's actually quite conceivable to have 0% taxable income from a rental property. If you needed proof that businesses are taxed more favorably in the US than individuals, look no further.
Takeaways
Real estate is an incredible investment opportunity over the long haul. Interest rates are near historic lows, so the cost to borrow is exceptionally low. What little interest that is actually due is deductible, most of the time. If you rent it out, then you get to deduct depreciation and a host of other expenses as well.
I’ve created a real estate tax deduction and depreciation calculator below for myself that allows me to plug in the stats for any property (including whether or not I am generating rental income with it) and calculate the potential first year return on the property. It’s relatively rudimentary, but as a broad instrument it’s quite useful. Keep in mind this isn't certified, and I am not an accountant, so I make no assertations that this is even close to accurate. Happy calculating!
