Many investors buy real estate for one reason alone -- its strength as a tax shelter. Income investment properties provide an excellent income stream, but the way that the Internal Revenue Service treats them lets you protect a disproportionately large portion of it from taxes. It allows you to write off operating expenses and depreciation and may even let you use taxable losses on your properties to offset other income.
The IRS lets you write off everything that you spend to operate the property. This includes obvious expenses such as mortgage interest, property taxes, property insurance, repairs you make to the property and utility bills you pay for the property. It also includes the management fees that you pay, even though they save you time and effort. You can even write off the cost of necessary travel to and from the property.
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Since a property is an asset with a long life, you can't write off the cost of purchasing it like you would for a pencil or a package of toilet paper. The IRS requires you to spread its cost over time through a process called depreciation. To depreciate your property, you separate the value of the land, which is not depreciable, from the value of the building and then divide the building's value by either 39 years, if it is a commercial property, or 27 1/2 years, if it is a residential or multi-family property. You can then write off that amount every year on your taxes until the property's value gets depreciated down to zero. For example, if you spent $4 million to buy an apartment property that consisted of a $900,000 piece of land and a $3.1 million apartment building, you'd be able to claim $112,727 in depreciation a year for 27 years, then $56,364 in depreciation for the 28th year, which is a half year. Any improvements that you make to the property or capital assets you buy for it also get depreciated.
Some of the expenses you claim against your property may spillover into items that you use personally. For example, if you use your personal cell phone to take calls for the property, you can expense a proportionate amount of your personal cell phone bill. If you own a rental in a vacation destination, such as Maui or Aspen, and travel there to spend a week and work on the property, you can write that entire trip off as long as you can document the tasks you completed. You can also write off a proportionate share of the cost of items you buy for yourself and for your property. For example, if you buy an all-terrain vehicle that you use 75 percent of the time for snow removal at the property and 25 percent of the time for recreational riding in the summer, you will be able to depreciate 75 percent of its cost. While these expenses are legal to claim, it's still a good idea to discuss them with an accountant just to be sure that you're doing everything the right way.
Passive Activity Losses
With the large number of deductions that you can claim against your rental income, it's entirely possible that you could end up with a taxable loss at the end of the year. The IRS may let you take up to $25,000 of that "passive activity loss" every year and use it to reduce your other taxable income. To be able to do this, your adjusted gross income must be below $100,000. As your income grows above that threshold, the IRS subtracts $1 of loss for every $2 dollars of income. For example, if your AGI is $130,000, you can't claim any of the losses, but if your AGI is $110,000, you can claim $20,000 of passive activity loss to reduce your taxable income.