There are limited tax benefits for middle-class Americans. Rental real estate has two tax benefits that can provide tax-free income to investment property owners and a tax-free windfall to heirs.
- Owners can depreciate residential rentals over 27.5 years. The depreciation can be used to offset rental income; meaning owners can receive rent from their property but have little to tax burden on that income
- Beneficiaries get a “step-up in basis” when residential real estate is passed down to heirs upon the owner’s death. Meaning heirs get to inherit the property at current market value—The difference between the book value of the property (original purchase price minus accumulated depreciation) and the current market value is transferred to heirs with no tax impact.
What these tax benefits mean:
- The current owner gets the advantage of tax-free income during his or her lifetime
- Heirs inherit a property at current market value with no tax consequence! Heirs can begin depreciation AGAIN at the market value instead of the old book value.
Real Estate in Oregon has appreciated at over 5% annually since 1975. So, if you buy a $500k property, you will (on average) gain around $25k in appreciation on the property each year. However, this compounds over time.
- The rule of 72: The rule of 72 says that dividing 72 by the interest rate on investment will produce the number of years it takes for an asset to double in value. 72 divided by 5 equals 14. So, at 5% appreciation, a $500,000 property will be worth $1 million in 14 years!
- If the rental income on a property covers the mortgage payment and repair costs, then it cost the investor no money to generate $500k in additional wealth
Investors can sell real estate, and the proceeds reinvested into other “like kind” property with no tax consequences by using a 1031 exchange. Through this process, an investor can continue growing his or her real-estate holdings without paying any capital gains on individual property sales. Taxes can be deferred to the future or eliminated by passing the real estate to heirs at the time of death.
When an investor borrows money to purchase an asset. A mortgage is a way to utilize leverage.
- Example 1: An investor pays cash for a $500k property that appreciates at five percent. His or her return on investment is five percent ($25k in appreciation divided by $500k investment equals five percent).
- Example 2: An investor buys a $500k property with an 80 percent mortgage. If that property appreciates at five percent, the return jumps to 25 percent ($25k in appreciation divided by $100k investment equals 25 percent).
- The return on investment increases because there is less money invested in purchasing the asset.
Interested in learning more? Contact Eric Dunlap, Loan Advisor, NMLS #169062, at 503-546-0460 or firstname.lastname@example.org.
*Peak Mortgage is not a tax consultation firm. Please seek advice from a tax professional.
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