With depreciation, your rental income profit could be tax free!

The objective behind owning residential income property is usually to make a profit. The property itself will typically appreciate over time, providing a nice profit down the road when you decide to sell. In the mean time we are striving for a positive cash flow from the rental income. That is, realizing a profit after all expenses are paid. 

  

Rental income is taxed as ordinary income; however, you will offset much of this income with your expenses related to owning and managing the property. Deductions include your true out-of-pocket expenses such as mortgage interest payments, property taxes, maintenance and repair costs, utilities, advertising for renters and professional property management fees. What’s left is your profit, taxable income.

But wait! There is a phantom expense allowed by the IRS. It’s called depreciation. Like any piece of capital equipment for a business, the IRS recognizes that your property, excluding the land, depreciates as it gets worn out over time. Basically (at the time of this writing) they say take the fair market value of your residential income property (excluding the land value) at the time it became a rental property, divide it by 27.5 and that amount of money can be deducted against your income each year for 27.5 years.

For example, if after deducting the value of the land, your income property is worth $550,000, you divide that by 27.5 and get a $20,000 annual deduction against your rental income. Have you owned your income property more than 27.5 years? Then it’s time to exchange it into a new property using the IRS 1031 Tax Deferred Exchange rules (see my March 19, 2012 post) and keep on going for another 27.5 years.

This is general information regarding residential income property tax advantages. Always check out all tax issues thoroughly with a tax accounting professional before making any real estate investment decision.