Owning rental property is a great wealth building tool. Less well known is the fact that your rental property can help you defer taxes for the near term. The simple equation for computing your schedule E rental taxable income is typically made up of the following:
Income = Gross Rent + Other Income
Expenses = Mortgage Interest + Mortgage Insurance (if applicable) + Homeowners Insurance + Property Taxes + Maintenance + Depreciation
Income – Expenses = Net Income/Loss
The most important of the expenses above is the depreciation expense. This figure can help you to defer the income you make on your rental property by deducting the depreciation on your rental house.
Consider the following example of a homeowner who invested in a duplex. The numbers below are his annual cash flow.
Rent Income: 15,000 Rent Expenses: 13,000
Based on his cash flow, he would recognize 2,000 in income for the year. However, once depreciation expense is added (a non-cash item) it is possible to recognize a loss (up to 25,000 if actively managed). If the homeowner bought the house for 200,000 and attributes 40,000 to the land (non-depreciable), he can depreciate 160,00/27.5 years = 5,818. Now, use this number with the figures above.
Rent Income: 15,000 Rent Expenses: 13,000 Depreciation Expense: 5,818 Net Income: -3,818
This loss (if actively managed) would then pass through on the schedule E to the 1040 and be deducted against other sources of income.
The Result of Deferring Taxes
The homeowner receives 2,000 in cash flow each year and successfully defers the tax on the 2,000 plus an additional 3,818 in other income. This tax savings strategy is how you can defer taxes until the rental property is sold.