24. Tax Benefits While Holding

In the previous chapter, the state exemption from income tax of all rental income has been mentioned. There are certain other advantages enjoyed by real estate owners which have been said to be the major reason for the truth of the saying "The only way left to get rich in the United States is in real estate."

The tax benefits that we enjoy while we hold the property are usually so profitable that it is easy to see why the saying came into being. To understand the most important one, we should first note that there are few, if any, ways in which a per­son engaged in business can lawfully receive money in hand that is truly profit, without paying a fat tax on it. But in real estate this is made possible and legal through the medium of depreciation.

It is impossible to over-emphasize the importance of this in your future fortunes. Next only to the fact that the Aunt Toby type of property supplies an essential of life at a unique profit to the supplier, the depreciation item is the greatest single con­tributor to our getting rich in real estate.

A simple definition of depreciation, as it applies to us, has been offered thus: Depreciation is allowed as a loss on the in­come tax return of a real estate owner, on the premise that his building has aged and depreciated during the tax year.

Any losses that other taxpayers claim must be actual cash paid out of hand. Not so for real estate owners. Here a tax "freak" obtains. It amounts to this. Nowhere in this book will you read any other single point that will affect your fortunes more.

Because of a "paper" loss, the cash you receive in hand from tenants is largely exempt from taxation.

The effect of this single phenomenon is far-reaching. Through it we are permitted to keep a substantial part of our income that in any other business would go to the government. In turn, this permits us to re-invest. That is, we proceed to in­vest that money in another and still another building to bring additional profit and additional depreciation allowances. This pyramiding is the rule, not the exception for real estate in­vestors.

Let us examine, by a simple example, how the depreciation item works.

You buy an Aunt Toby for $11,000. You value the land (and it's largely up to you) at $1,000 and the building at $10,000. Here is how your net taxable income would be affected in the Profit and Loss statement of the building.

Total rents received                                                             $2,700.00
Less Expenses:
Taxes                                                                                  $400.00
Interest on Mortgages                                                          $580.00
Water                                                                                  $50.00
Insurance                                                                             $40.00
Repairs                                                                                $230.00
Depreciation: 5% of $10,000. (3% on brick buildings)         $500.00
Total Expenses & Losses...                                                  $1,800.00
Deduct from income                                                             $1,800.00
Net taxable profit                                                                 $900.00

(But note that the Depreciation item of $500 is money you actually have NOT paid out!)

Thus, assuming you had no vacancies, you would transfer to your tax return for your regular exemptions and deductions. This is quite different from being forced to pay tax on $1400. Yet you are permitted to receive and use that $500 for re-investment.

Any tax accountant will tell you that this is a "dream" deal from the tax approach. To be allowed to make a profit of $1400 and actually receive $1400 in hand—and to be permitted to pocket $500 of it tax free (for 20 years) gives you an enormous boost toward becoming wealthy. It is precisely this point that has been the basic reason why real estate owners have received such a huge percentage of their investment back in hand with which they could re-invest, pyramid and do it quickly!

Granted that they would have generally received their in­vestment in hand in two, three or four years anyway, we must not overlook the grim truism that anyone who receives profit must not count his blessings until he has lopped off the part that must go to Uncle Sam. It is the allowance for depreciation that makes all the difference.

There are other significant tax allowances in the ownership of real estate. You should take full advantage of them. For in­stance any improvements you make in the building are dis­tinguished from normal repairs. Routine maintenance and re­pairs are classified as a direct expense and are deductible in full on that year's return.

However, improvements, such as the installation of a new roof or heater are not considered repairs, but are classified as Capital Improvements. From a tax standpoint, you are per­mitted to take deductions for these, but only over a period of years, usually eight or ten. Thus a $1000 expenditure for a roof permits you to deduct a loss of $100 each year for ten years.

Recently a new law was passed that gave an extra tax exemp­tion to new owners of property. You will want to take advan­tage of it. Formerly, when you bought a building and spent some substantial sums on improvements, you were limited to taking, as a deduction, y$ or %o of the expenditure each year for 8 or 10 years until you had used it up. This still obtains as to roofs, sidewalls, heating systems etc. Some recent changes and clarifications in the tax law have given special benefits to owners who install equipment such as stoves, refrigerators, sinks, airconditioners etc. On these, you can deduct the usual 10% or 12M plus an additional 20% in the first year. (This has a $2000 maximum on the 20% to any one person.)

Let us say you buy a building and install $3,000 worth of equipment. You take the usual $300 (10%) the first year as a deduction, plus an additional $600 (20% of $3,000) and your total deduction for the first year is $900 on your tax return.

You will, of course, use up the 100% of the expenditure more rapidly, but it's worth it to get back your investment as soon as possible for re-investment.

Remember, all painting is deemed a repair, even though the work is effective as an improvement for many years. You de­duct the entire cost of a paint job, exterior or interior in full on your next tax return.

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