Quick Tax Examples##
Let's assume that you purchased a house for $1 million and sold it in 2021 for $1.6 million after living in it for 10 years. The yearly property taxes you pay to your county are at 1.25% (or $12,500 a year), and the mortgage interest you pay is $50,000. And finally, you are going to be filing taxes, married, filing jointly, and your marginal tax rate is 32%. We'll also assume that you are not using your house for any business in this example.
|Increases||Decreases||Tax impact (example)|
|Yearly Taxes||Property tax rate Substantial improvements||Property tax paid Mortgage interest (points etc.)||The total amount deductible is $62,500.00. At the marginal rate of 32%, that would be $20,000 for this year.|
|When you sell the house||Selling price||You can deduct expenses incurred in selling the house.||Deduction of gains up to $500k (married filing jointly) reduces taxable gains to $100,000. At capital gains rate of 28% this would be $28,000.|
Things get a bit more interesting with income-generating properties. We must also consider rental income and other expenses used to generate that income. In addition, we need to consider depreciation. In our experience, depreciation is where many of our customers trip up.
So, let's set up the example again. Assume that you purchased a house for $1 million and sold it in 2021 for $1.6 million after renting it out for 10 years. The yearly property taxes you pay to your county are at 1.25% (or $12,500 a year), and the mortgage interest paid is $50,000. You collect monthly rent of $3,000, and the monthly expenses (like HOA, etc.) are $500. The house's value is $1000,000 is split into the value of the land at $600,000 and building ($400,000). You are also filing taxes as married, filing jointly, and your marginal tax rate is 32%. In this example, we'll also assume that you are not using your house for any business.
|Increases||Decreases||Tax impact (example)|
|Yearly Taxes||Property tax rate Substantial improvements Rental income||Property tax paid Mortgage interest (points etc.) Depreciation Monthly expenses||Your rental income of $50, 000 is taxable but can be reduced by the following. You can deduct mortgage interest ($50k), property taxes paid ($12.5k) HOA and other expenses ($6000) and deduction of $400,000 / 27.5 = $14,545.45 Total taxable income is $35354.55, which comes to $11345.45 for this year.|
|When you sell the house||Selling price Depreciation (which increases the longer you have held the house)||You can deduct expenses incurred in selling the house.||The house was sold for $600,000 gains. Those are taxed at capital gains of 20% so $120,000. But we also have to pay depreciation recapture tax on the amount where we did not pay depreciation for the last 10 years. That amount is 10 * 14,545.45 = 145,454.50. At 25% that comes to $36363.62. Total taxes due on selling this property after 10 years are 36363.62 + 120,000 = $156, 363.62|
Basics of Taxation##
The concept of taxation, even real estate taxation is very simple. It is the details where things fall apart.
The concept of taxation, even real estate taxation, is straightforward. It is the details where things fall apart. Let's start at the beginning. You make a loss or gain when you buy and later sell that asset. The government wants its cut. You buy something for $100 and sell it for $120, so you have made a gained $20. Or if you sell it for $80, you have a loss of $20. In most cases, the loss or gain is added to your net income. There are exceptions to this, but we will assume you are an individual or a family and not a corporation.
You can file taxes either as an individual or with your partner (spouse) in the US. The limits of deduction and exemptions are different from how you file taxes. The Internal Revenue Service (IRS) also distinguishes whether the property is your primary house or is used for generating income (like a vacation home that is rented out most of the time or rental property).
Taxes in a non-sale year##
Of course, taxes are not just due when you sell a house. They are due regularly.
Let's start by talking about taxes for an income-generating property. The income that you generate in a year is also taxable. But you can reduce that income by deducting some of the money you spent to create that income (incurred expenses). For a rental property, the list of things that can be used to reduce taxable income is
- Interest paid on your load (mortgage interest)
- Yearly property taxes paid to the county
- Depreciation (we will cover this in detail)
- Home Owners Association (HOA) dues
- Repair and maintenance costs (including supplies, materials and, labor)
- Expenses like appliance repairs or replacement
- Necessary expenses like interest, taxes, advertising, maintenance, utilities and, insurance
Yearly taxation for your house (non-income generating) is much simpler. The IRS allows you to deduct the mortgage interest you have paid from your total taxable income in a given year.
If you don't own an income-generating property, you can safely skip this sentence. Depreciation is a weighty topic for rental real estate. Again, like all things in accounting and taxation, depreciation is simple to understand but hard to calculate. To understand depreciation, you must understand the difference between ordinary and capital expenses. Ordinary expenses are also called operating expenses. They include paying your HOA dues, paying for lawn maintenance, etc. They are paid regularly and are usually the same amount each month. When you make big purchases or improve the house, for example, by adding a room, you typically spend thousands to hundreds of thousands of dollars. You can't reduce your income in that year by that amount because it is considered a capital expense. This is good since we likely, don't have enough rental income to offset that amount. So how do we handle this large amount of money (or capital) spent?
This is where the concept of depreciation comes into play. Depreciation allows you to write off a portion of the capital expense each year for several years. There are many ways of calculating depreciation. A common method of depreciating assets is Straight Line. Let's say that you purchased something for $100,000 and want to depreciate it over 50 years. So, each year you will depreciate the asset by 100k / 50 =$2000. At the end of 50 years, the purchase would be worth $0.
At its heart, depreciation is a way to model how things lose their value when they provide a service to you. In other words, it is an attempt to put a number to the value of service of an asset. This is because everything has a finite life span.
The value of service is the amount by which an asset depreciates. You might think that the value of service of an asset depends on how much you use that asset each year. But to simplify things, remove subjectivity and make sure everyone uses the same methods, accounting types have fixed ways of depreciating items.
The Internal Revenue Service (IRS) has a standard method for depreciating real estate. It is called the Modified Accelerated Cost Recovery System (MARCS). The key concept is that the value of your house is split into two components - the cost of land and the cost of the actual building. This is important for depreciation since you can't depreciate land as it does lose value. It does not break down and becomes unusable. The useful life is defined as 27.5 years by MARCS for real estate. So if you purchased a house for $1 million and the value of land is $600k of that $1m purchase, depreciation is $21818 each year.
So how do you handle depreciation?##
Depreciation is both a blessing and a curse. In your yearly taxes depreciation helps you reduce your taxable income from the income generated by the property. So, depreciation of $21,818 at the marginal tax rate of 25% will save you $5454.5 in taxes. However, loses can be carried forward indefinitely
Depreciation when you sell the house##
This is where things get interesting. depreciation, as the name suggests, is for a depreciating asset. But real estate is generally not a depreciating asset. When the house is sold for a loss, it is not as much loss as what you have depreciated. Also, the longer you hold the property, the more depreciation has been used, which means the tax bill is higher.
So how does that work?
This is where Depreciation Recapture tax comes in. To understand ***Depreciation Recapture, let's take a simple example. Let's say that you bought a rental property for $1million and sold it after 10 years for $1.2 million. That is a gain of $200k in 10 years, and typically you'd expect to pay a capital gains tax on those $200k (say at the rate of 25%), so 50k. The original price of the house ($1 million) in this case is known as the adjusted cost basis. According to IRS, because of depreciation, the adjusted cost basis of the house is not $1 million, but lower, which means your taxes will be higher when you sell this property. How is that, you ask?
Let's go back to the first principles and look and look at how we used depreciation when we reduced our tax burden. Tax is due on the gain you made in a transaction. Gain is calculated as the difference between your value and the value to someone else. Value to someone else is the price they paid you for the real estate asset. The value to you goes up or down. It goes up as a result of the improvements and goes down due to depreciation.
When you depreciate a house, you reduce the tax burden that year since you are essentially saying that the property's value is a bit lesser than the year before. So, the IRS allows you to reduce the tax burden that year. The total depreciation adds up when you sell the house, and the cost basis goes down by a similar amount.
Frequently Asked Questions##
What happens if annual depreciation is more than your income that year?##
This is considered as Passive loss. It cannot be deducted against regular income.
Quick Numbers (2021)##
Marginal Tax Rates##
|Single||Married, Filing Jointly|
|Less than $40, 400||Less than $80, 800||0%|
|Less than $445,850||Less than $501,600||15%|
|More than $445,850||More than $501,600||20%|
Income tax brackets##
|Single||Married Filing jointly|
|Less than 9,950||Less than 19,900||10%|
|Over 9,950 but less than 40,525||Over 19,900 but less than 81,050||12%|
|Less than 86,375||Less than 172,75||22%|
|Less than $164,925||Less than $329,850||24%|
|Less than $209,425||Less than $418,850||32%|
|Less than $523,600||Less than $628,300||35%|
|More than $523,600||More than $628,300||37%|