No, the IRS didn't forget about your investment property, and the tax deductions you took

Hey! Did you know I'm not a tax attorney or investment advisor? Well, I'm not, so make sure you remember that, as this is just a layman's example of how the IRS can trip up the unwary investment property owner.

 

One of the great things about real estate is you can defer taxes on investment property. How does that work? Well, it's pretty simple, in concept.

 

The IRS assumes that your property depreciates over its life span (which we will assume to be around 25 years, to keep things simple). Let's say I own a two-family, and I paid $400,000 for it. I borrowed 80% of the money, or $320,000. When I look at the assessor record, it says:

Land: $175,000

Building: $200,000.

 

Yes, I know that only adds up to $375,000. But I'm going to try to make this example realistic, and assessments don't often equal home values. At any rate, we have a pretty good breakdown, for tax purposes, of what the building is worth: 200K. Now the IRS will let me depreciate that building, 1/25th each year, which is about $8,000. Note, the land doesn't depreciate. (Of course, if you own a condo, you may not own any land, so almost the full amount will be depreciable). If my building "made" $3000 in income, I can offset that income with $8000 in depreciation, and I now have a $5,000 loss on the building as whole. This loss can offset other income on my taxes, and then I will save taxes on that offset income. More simply, if I made 100K at my job, the IRS now looks at the 100K as if I only made $95,000, as I took a $5000 loss. Since I make less, I pay less in taxes (one would hope!).

 

 

Pay less in taxes? Sounds great! Is there a catch?

Of course there is! Let's say you sell the building in 10 years. Over that time frame, the building has been regularly updated and maintained, and has appreciated, on average, 3% a year. For you math wonks, that's 400,000*1.03^10, which is approximately 530,000. Nice right? You made $130,000! Well the IRS thinks you did better than that.

 

The depreciated value of the property, according to the IRS, is only $120,000 at time of sale. Huh? What? Easy: You deduced 8,000 in deprecation for 10 years, or $80,000. Originally, the basis was $200,000, so 200-80=120K.

 

When you sell the property, the IRS looks at the difference in the depreciated value (120) and the final sale price (530). That's $410,000, and they want capital gains taxes on $410,000.

 

But wait, you say, I only made $130,000! The taxes on $410,000 is going to really sting!

 

You bet! 20% of $410,000 is $82,000. That's a big check to write. Let's look at your math at time of sale.

 

 

  • Purchase Price: $400,000.
  • Sale Price: $530,000
  • Loan Payoff: $250,000 (Assuming you have paid the minimum on a 30 year loan at 5% or so.)
  • Taxes: $82,000
  • Profit after taxes: $198,000

 

 

Whew! At least we still did very well - $198,000 after taxes and after the bank has been paid. So what's the problem?

 

 

Just because your property has been appraised for a higher valuation, beware of the cash out!

In good times, there is no problem. Real estate values generally go up, and the amount you owe on a mortgage generally goes down. But lets take the same example as above, and in year number five, let's borrow some more money.

 

In year number 5, the bank says my property appraises at $460. I borrow against that 90%, which is an additional 100,000 or so, leaving my mortgage balance(s) at $417,000. In five years, I still owe $375,000. Now here's how I look at time of sale:

 

 

  • Purchase Price: $400,000.
  • Sale Price: $530,000
  • Loan Payoff: $375,000 (Assuming you have paid the minimum on a 30 year loan at 5% or so.)
  • Taxes: $82,000
  • Profit after taxes: $73,000

 

 

Uh-oh. Not much less left over in this scenario now. Over 1/2 of my sale gain went to the IRS.

 

A Declining Market can Wipe Out the Over Leveraged Property Investor

But the real risk is a declining market. If I take the above example, and prices fall, right after I borrow the money, I'm in real trouble. Let's say when I sell, the building value has fallen just 5% from when I borrowed.

 

  • Purchase Price: $400,000.
  • Sale Price: $437,000
  • Loan Payoff: $375,000 (Assuming you have paid the minimum on a 30 year loan at 5% or so.)
  • IRS taxable gain: $257,000
  • Taxes: $52,000
  • Profit after taxes: $10,000

 

See the problem? You started with 80,000 as a down payment, but after sale of the property and paying the tax man, you've only got 10,000.  Now, to be fair, you did take cash out of the property, so you're pretty much back where you started, but getting back where you started isn't so great after 10 years.  Worse, if this was a condo, or if you had managed to borrow against the property even more, you could have to pay the IRS money from your pocket at closing.  What happened?

 

A couple of things, the biggest of which was being overleveraged in a declining market.  This is bad!  It's one thing to borrow against your house, which you live in, and generally the appreciation is tax free, but the same tactics do NOT apply to investment property.

The other thing we're not talking about is the cash flow the investment generated over it's life span.  That was quite a lot - considering the amount of money put at risk - so it's not really as bad an investment as it looks - assuming, of course, you did have positive cash flow.