Please help me understand the tax implications here

[Columbus]

Okay so if you're a high income earner. Let's say over $400-500K per year. You decide to buy property for let's say $120,000 CASH. $20,000 of that is land and $100,000 that you can depreciate

So you depreciate $100,000 over 27.5 years and you get to write off $3636 per year against your taxable income. Now, you save probably 39.6% of $3636 in taxes which is about $1440.

So let's say you sell the property after 27.5 yrs, then you gotta pay 25% recapture tax on that $100,000 you wrote off. That's $25,000 right there. That feels like a big punch compared to the $1440 you got to save for 27.5 years ( well considering you got to save 39.6% every year). What I am saying is that when you make $400-500K, that $1440 seems negligible amount but when you gotta pay $25,000 at the sale time, then not so much.

Plus the need to rent to have cash flow etc requires time and effort.

So is it worth paying cash? Remember you had $120,000 cash in the bank and you already paid taxes on it

Is real estate worth it or is stock market worth more since you're original money will not taxed again.?

Stocks will require research time and no other effort such as getting call from tenants.

Of course one advantage of real estate is Leverage but sometimes cash offers get a better deal.

So why is real estate considered superior to stocks by so many ? Thanks

[jfoxcpacfp]

Columbus wrote:

Okay so if you’re a high income earner. Let’s say over $400-500K per year. You decide to buy property for let’s say $120,000 CASH. $20,000 of that is land and $100,000 that you can depreciate

So you depreciate $100,000 over 27.5 years and you get to write off $3636 per year against your taxable income. Now, you save probably 39.6% of $3636 in taxes which is about $1440.

So let’s say you sell the property after 27.5 yrs, then you gotta pay 25% recapture tax on that $100,000 you wrote off. That’s $25,000 right there. That feels like a big punch compared to the $1440 you got to save for 27.5 years ( well considering you got to save 39.6% every year). What I am saying is that when you make $400-500K, that $1440 seems negligible amount but when you gotta pay $25,000 at the sale time, then not so much.

Plus the need to rent to have cash flow etc requires time and effort.

So is it worth paying cash? Remember you had $120,000 cash in the bank and you already paid taxes on it

Is real estate worth it or is stock market worth more since you’re original money will not taxed again.?

Stocks will require research time and no other effort such as getting call from tenants.

Of course one advantage of real estate is Leverage but sometimes cash offers get a better deal.

So why is real estate considered superior to stocks by so many ? Thanks

Click to expand...

So you saved $39,600 by depreciating the real estate and you pay $25,000 of it back. You are ahead $14,600. After 27.5 years, you are going to sell for more than $100k, right? Let's say $300k and assume tax law remains the same, which is doubtful but the only way we can look at it. On the $200k gain, you will pay 20% LTCG tax, or $40,000. If you didn't have LTCG, you would pay ordinary income tax, or $79,200. That's another $39,200 you've "saved". Your "feelings" don't matter, numbers do, and they don't lie. You also should have a financial plan to be prepared to pay the taxes at sale (remember, you'll have $300k in this example from which to pay them).

Your original money is not taxed "again" in either situation. You are taxed on the gains. You are not allowed to depreciate stocks, of course, so you do not have any yearly deduction. And on the real estate, you will likely have suspended losses which will be used when you finally sell the property. You are not really making a fair comparison.

Having said that, I will almost always choose a diversified equity fund portfolio, rebalanced annually, over real estate.

Your CPA or CFP should be able to help you understand your concerns with more clarity.

[meccos]

The other thing I think we should clarify is that you can write off this depreciation against your passive income only.  Therefore unless you are cashflow positive on your rental or other forms of passive income, you may not be able to write off anything.  The depreciation you take every year can however be used in the future, if you do have passive incomes.

[Sajimone]

jfoxcpacfp wrote:

So you saved $39,600 by depreciating the real estate and you pay $25,000 of it back. You are ahead $14,600. After 27.5 years, you are going to sell for more than $100k, right? Let’s say $300k and assume tax law remains the same, which is doubtful but the only way we can look at it. On the $200k gain, you will pay 20% LTCG tax, or $40,000. If you didn’t have LTCG, you would pay ordinary income tax, or $79,200. That’s another $39,200 you’ve “saved”. Your “feelings” don’t matter, numbers do, and they don’t lie. You also should have a financial plan to be prepared to pay the taxes at sale (remember, you’ll have $300k in this example from which to pay them).

 

Click to expand...

Also.. if you do a 1031 exchange at the time you sell.. you don't pay any taxes either.   My strategy is to hold these properties long term.. use the depreciation to save on the taxes.. upgrade to bigger properties through more 1031 exchanges.. hopefully have more passive income from these rental properties in the long term.. and then pass on to my kids with a stepped-up basis.  Unless the rules change.. no taxes will ever have to be paid.

[NJDoc]

Columbus wrote:

Stocks will require research time and no other effort such as getting call from tenants. Of course one advantage of real estate is Leverage but sometimes cash offers get a better deal. So why is real estate considered superior to stocks by so many ?

Click to expand...

In my mind it is not necessarily superior, but rather different. Real estate (not REIT's) provides diversification in your portfolio, outside of the risks of the broad market. In addition, for many of us the tax sheltered cash flow is nice to have. "Diversify by source of return", was drilled into my head by a well heeled mentor.

You are correct, leverage is a fundamental tenet for many real estate investors, but in retirement wouldn't it be nice to have a fully paid off positively cash flowing asset that technically is self adjusting for inflation?

Lastly, the tenant issue is a very valid concern and because of that I personally have chosen not to buy small single properties that require my time and management. Instead, I ended up going into bigger properties with other investors that use professional management and also have lately shifted to larger syndicators and invested in their funds. Again, diversifying both geographically in the US and across various real estate asset classes.