Welcome to The Saucetown Investor: Unlocking the Secrets of Real Estate Depreciation

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The Tax Trials of a Former President

Unless you’ve been living under a rock since 2016, you’ve likely heard about the tax trials and tribulations of a certain former and soon-to-be current President of the United States. Before Donald Trump took office, his narrative revolved around being a New York City real estate developer. While he may claim to own more of “The City” than he actually does, he undeniably remains a significant player in the NYC real estate market.

Trump’s relationship with taxes has been anything but transparent. Notably, he broke the tradition of U.S. Presidents sharing their tax returns with the public during the 2016 campaign. This decision was likely strategic; years later, he was ordered to pay over $450 million in damages related to various financial crimes in New York State. Sharing his tax returns back then would have subjected his business dealings to intense scrutiny, making his reluctance understandable.

His tax strategies have ranged from outright illegal activities, such as tax fraud, to questionable practices like overvaluing properties for banks while undervaluing them for the IRS. However, amidst these controversies lies a crucial aspect of the tax code that Trump leveraged repeatedly: depreciation. The best part? It’s completely legal, and you can utilize it too. Depreciation is often overlooked but is the holy grail of real estate investing.

Understanding Depreciation

Before diving deeper, let’s clarify that I am not a CPA and cannot provide tax advice. This piece is for informational purposes only. If you decide to navigate these waters on your own and find yourself facing an IRS agent, that’s on you, not me.

The IRS defines depreciation as “an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property.” This concept applies across various sectors. For instance, a farmer can depreciate the cost of their tractor, and a restaurant owner can depreciate their industrial oven.

For our discussion, we will focus specifically on how depreciation applies to real estate. In personal finance, many “gurus” often emphasize cutting your biggest expenses, typically housing and transportation. However, in reality, your largest expense is often taxes.

The Real Estate Advantage

One of the oldest adages in finance is, “It’s not what you make, it’s what you keep.” This saying holds true, especially when considering that, depending on your state, up to 50% of your income may go toward taxes if you’re a W-2 worker. You may have heard that “real estate investors don’t have to pay taxes,” but how does that actually work? Let’s break it down with an example.

A Case Study: The 8-Plex Investment

Imagine Donald buys an 8-plex in Salem, OR, for a million dollars. In this scenario, the building is valued at $800,000, while the land is worth $200,000. Over the course of the year, the building nets $25,000 from rents after accounting for repairs, mortgage interest, taxes, insurance, and other expenses.

At this point, you might think it’s time to pay the IRS and the State of Oregon. However, in residential real estate (note: this must be an investment property, not a personal residence), property is depreciated over 27.5 years. In commercial real estate, the depreciation period extends to 39 years.

The Mechanics of Depreciation

So, what does this mean in practical terms? The IRS allows property owners to deduct depreciation as a way to account for wear and tear on the building. For example, if you invest $20,000 in a new roof with a lifespan of 20 years, that roof will not retain its full value over time.

Let’s do the math. If our building is valued at $800,000, we can calculate the annual depreciation as follows: $800,000 divided by 27.5 years equals approximately $29,090. This amount becomes a tax write-off.

Now, remember that our 8-plex produced $25,000 in net income. Instead of facing a tax bill on that income, we can apply our $29,090 tax write-off. This means that instead of reporting $25,000 in taxable income, we actually show a tax loss of $4,090. In a twist of irony, we’ve made a net income of $25,000, yet the IRS owes us money instead of the other way around.

The Power of Real Estate Investing

This example illustrates the significant advantage of real estate investing. A W-2 worker might owe half of that $25,000 in taxes, leaving them with only $12,500. In contrast, the owner of the 8-plex retains the entire $25,000, plus the added benefit of a tax write-off.

This principle applies regardless of the scale of your investment. Whether you’re dealing with a small duplex or a large apartment complex, the same math holds true. As you pay down your loan principal and hopefully watch your property’s market value increase, the results can be astounding over time, especially when compounded.

The Best-Kept Secret in Real Estate

Every day, new strategies are promoted by your favorite “gurus” on social media. One day it’s wholesaling, the next it’s house flipping, and then it’s sub2. While these are all valid strategies, depreciation remains the best “hack” in the game. It has been a part of the U.S. tax code since the 1830s.

The formula is simple: buy and hold rental property, generate cash flow, pay no taxes on that cash flow, and watch your property’s value appreciate over time while you pay down your mortgage. Rinse and repeat.

In the world of taxes, the term “loophole” often gets thrown around. The U.S. tax code is extensive, leading to ambiguity and grey areas. However, depreciation is not one of those grey areas; in fact, the IRS virtually requires you to utilize it. Whether you’re constructing skyscrapers in New York City or purchasing your first duplex in Salem, OR, real estate can help you not only “make it” but also ensure that you “keep it.”

Conclusion

In conclusion, understanding and leveraging depreciation can significantly enhance your real estate investment strategy. It’s a powerful tool that allows you to maximize your income while minimizing your tax liabilities. As you embark on your real estate journey, remember that knowledge is power, and the more you understand about the tax code and its benefits, the better equipped you will be to make informed investment decisions. Welcome to the world of real estate investing—where the right strategies can lead to financial freedom and success!