by No Comments
Summary: One advantage of investing in rentals for cashflow over other forms of investing, is that you often don’t pay taxes on the profit. This is one of the greatest benefits of investing in real estate. In this article we will show you how you can still generate profit on your rental property, but show a loss on your tax return.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
[2022 Update: This article was originally published in April 2018. We updated this article by adding information about the tax benefits you can get from short-term rentals.]
When comparing real estate investing to other forms of investing, it’s important to consider the tax consequences.
When you sell a stock for a gain, you pay capital gains tax. When you receive a dividend, it’s taxed as ordinary income.
But what about the tax consequences of any profits you make from your rentals?
This is one of the unique aspects of investing in rentals for cashflow.
It’s often the case that you’ll pay zero taxes on the cashflow.
In order to understand how, you’ll first need to understand how taxes are calculated.
Taxes are based on net income or loss. This is what you have left over when you subtract all expenses from your rental revenue.
Typical expenses for a rental property are things like insurance, property taxes and utility costs.
For tax purposes, the IRS lets you deduct other expenses called phantom expenses.
Phantom expenses are exactly what they sound like. They aren’t true expenses. You don’t have to actually pay out of pocket for these expenses.
Typical expenses for a rental property are things like insurance, property taxes and utility costs.
For tax purposes, the IRS lets you deduct other expenses called phantom expenses.
Phantom expenses are exactly what they sound like. They aren’t true expenses. You don’t have to actually pay out of pocket for these expenses.
Tax calculations for an example duplex
Let’s use an example to demonstrate how you can make money from your property, while at the same time, show a loss on your tax return.
Let’s say that you have a duplex that you bought for $250,000.
Cashflow is calculated by subtracting operating expenses from rental revenue. You don’t include phantom expenses when calculating cashflow.
The cashflow from this duplex is $5,500. This is the amount that you would have in our pocket at the end of the year.
However, when reporting the income and expenses for this property on Schedule E, you include phantom expenses. When you include phantom expenses, this tips your income into negative territory. In this example, your tax returns show a loss of $5,600.
As you can see with this example, the $5,500 of cashflow isn’t taxed because on paper, this property lost money.
Using these losses to lower your taxes
You might be wondering, can I somehow benefit from these losses?
The answer is, YES!
In certain situations, you can use these losses to offset your W2 or 1099 income. For example, if you make $200,000 per year in salary, the $5,600 loss would lower your taxable income to $194,400.
So what are these situations? One is, qualifying for something called real estate professional status. Another is with the short-term rental tax loophole.
How to create an even bigger loss using bonus depreciation
Lowering your taxable income from $200,000 to $194,400 isn’t very exciting.
However, with rental properties, there is a way to create an even bigger phantom expense.
This is with something called bonus depreciation.
You can read more about bonus depreciation HERE.
Using the same example as above, we replace the regular depreciation of $9,600 with a much bigger depreciation number of $62,500. This results in a loss of $58,500 instead of just $5,600 with regular depreciation.
This is how you can create large losses to offset W2 or 1099 income when you have real estate professional status or you use the short-term rental tax loophole.
What if I don’t have REPS or don’t qualify for the short-term rental tax loophole?
Many people ask whether or not you have to be a real estate professional or qualify for the short-term rental tax loophole to receive the benefits of investing in real estate. The answer is a resounding NO! While offset income with REPS or short-term rentals is a great benefit, anybody can earn tax-free income from investing in real estate and significantly lower their taxable income.
For example, let’s say you earn half of your income from cashflow and the other half from a job. Assuming the cashflow is tax-free as in the above example, then you just cut your tax rate in half!
Now that’s a great way to jump start your journey to financial freedom.
Have you found a way to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD Facebook page and join our Physicians (for MDs or DOs only) or Professionals group!
Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.
In other words, you put money in your pocket from your rental, and the government gives you back even more money at tax time (assuming you are a real estate professional, see below for more details).
