There are three basic types of investments you can make: paper assets, business and real estate.
Of these, real estate can give you the best tax breaks. To understand that, you need to understand two types of expenses: deductible and non-deductible. And deductions also come in two types: actual and phantom. That’s where the gold is.
An actual expense is something you spend money on. For example, if you have a business and you buy paper for your printer, it’s an actual expense. It’s also a deduction. A phantom expense is a deduction that doesn’t cost you any cash. In this case, real estate has a very big phantom expense. It’s called depreciation.
When you buy improved real estate, chances are you plan on having appreciation. Hopefully, you’re also looking at positive cash flow. Without cash flow, you have to feed the real estate investment every month. And if the property goes down in value, or the upward climb isn’t what you thought it would be, you’ll be in the same position real estate investors were about 6 years ago. Cash flow is king when it comes to real estate, but that’s second only to the tax break.
While we all invest for appreciation, the fact is that the IRS gives us a huge break in the form of depreciation. If you have a residential property, you can depreciate the real property part (building frame itself) over 27.5 years. The personal property part (HVAC unit, flooring, etc) can be depreciated over 7 – 15 years. The land portion of property is not depreciable.
A commercial property is depreciated over 39 years, but the personal property portion is still depreciated over a shorter life.
There is a possible problem to all of these deductions, though. If you create a tax loss, you may not be able to offset your other income with it. Real estate investments create passive income/loss. If you make less than $100,000 in adjusted gross income (AGI), you can deduct up to $25,000 of the loss against other income. If you make more than $150,000, you can’t deduct any of it. Between $100K and $150K, the deduction amount phases out.
If you or your spouse is a real estate professional, you get all of the deduction, no matter how much it is or how high your income is. Look back a few day’s ago for a blog on the real estate professional status.
The secret to all of this is making sure your strategy supports the deductions you want to take. Tomorrow, I’ll tell you the story of a new client I got that missed a huge tax saving strategy by just one year.
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