Loans Answers

Advice needed

Question: I’m thinking about investing in a home for purposes a generating a modest positive cash flow through renting. I will sell some stocks to generate any required cash. Will the initial tax benifits of the investment offset the liabilites from the sale of the stocks?

An example would be helpful.

Answer: simply do an amortization on your proposed purchase, then calculate the tax savings of deducting that interest amount from your gross income. this assumes that you are itemizing your taxes. If you are buying the property for investment purposes, mot a residence, then you can also deduct the “purchase costs” and maintenance costs, as well as annual depreciation of a the purchase price over 27.5 years. (this amount will eventually be taxed when you sell, but it’s always better to pay taxes later). Consult a competent tax accountant. He meant to say “cost recovery.” It’s an income tax issue. We use to call it “depreciation,” but the tax laws were changed and the new term is “cost recovery.”

The idea is that the building becomes worthless at the end of its economic life. That is, eventually the building will be so out of date that it must be torn down. Therefore the investor must allocate a portion of the income to replacement of the structure many years from now. The income tax laws allow the investor to claim this amount annually as an expense, even though it doesn’t have to be paid annually.

Many years ago the investor had to estimate the remaining economic life of the structure. Naturally, the shorter the life the greater the annual amount of cost recovery. Since the cost recovery amount usually put the investment into the red (on the books), there would be a loss to report on the investor’s tax return. The shorter the economic life, the greater the paper loss. This loss could be used to offset income from other sources. This is why a real estate investment is usually referred to as a tax shelter.

Back when Reagan was president he got Congress to change the tax laws to provide for a flat 27 1/2 years economic life for residential investment property and 39 years for other kinds of property. The reason for this was because the investor and the IRS used to argue constantly about the real remaining economic life. The investor would claim it was shorter in order to increase the annual paper loss, and the IRS would claim it was longer. Now we just use an arbitrary number and there is no arguing.

You cannot claim cost recovery expense on a personal residence, on vacant land, or on the portion of an investment in an improved property that is allocated to the land under the building. It can be claimed only on structures, and only on those that are held for the production of income, on speculation, or for trade or business purposes.

Note that cost recovery is an income tax fiction that has nothing to do with the real market value of the property.

I should also add that there is a related issue that should be mentioned — capital gains. When you sell the property you must pay tax on the profit. The profit is based on the remaining economic life (unrecovered basis) at the time of the sale, not the original purchase price. So every year when the investor claims the cost recovery it is increasing the pain when the property is sold down the road. Of course, there are ways to alleviate that pain to some degree, but that is beyond the scope of this post.

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