Is Real Estate Really an Investment?

Part II

How income tax deductions benefit real estate investment return

Although we are not tax law professionals and recommend that all questions concerning income tax deductions are best referred to an experienced tax expert; it is important to understand the mechanics of real estate income tax deductions and how they affect the comparison between which investment return is better: the S&P 500 Index or real estate.  Additionally, how each investment may benefit your specific financial position.

In many countries, including the United States, one is able to deduct the cost of numerous second home ownership necessities.  In basic terms, taking a tax deduction against your income means that you are able to subtract the amount of paid mortgage interest from your income, which reduces your “taxable” income, and more importantly the amount that you may owe to the government annually.  Depending on the method of ownership, in most instances, the following components are considered deductable: mortgage interest, property taxes, maintenance/repairs, expenses, and depreciation.  However, monies received through any rentals are considered income and need to be claimed as such.  The ability to claim these components as income tax deductions can lessen your financial responsibility to the government.  The best way to illustrate the benefits of tax deductions is through a short example.

Investment Home Price: $300,000

Down payment: $60,000 (20%)

Mortgage Amount: $240,000

Interest Rate: 6%; 30 year fixed rate mortgage 

Monthly Estimated Carry Cost:

Mortgage: $1440/mth (Principal and Interest)

Taxes: $400/mth (Estimated)

Insurance: $75/mth (Estimated)

Total: $1,915/mth

Possible Tax Deductions:

$14,400 (1^st Year Mortgage Interest) = $240,000 * 6%

$ 4,800 (Estimated Property Taxes)

$ 3,000 (Estimated Maintenance/Repairs)  (i.e. Painting/Carpet/Landscape/Other)

$ 3,000 (Estimated Expenses) (i.e. Advertising, Utilities, Insurance, Phone, Mileage)

$ 8,727 (Estimated Depreciation) (Depreciated over 27.5 years) (i.e. $240,000/27.5 = $8,727/yr)

Total Deductions: $33,927 * 33% (tax bracket) = $11,295 of Possible Income Tax Savings.  This number could be more of less depending on each owner’s tax bracket.

Estimated Rental Income = $2,500/mth = $30,000 Income added to owners income

The above example shows that the owner in this situation paid about $22,980 to carry the investment property for one year.  It was rented to an interested party at $2,500 per month which totaled an annual rental income of $30,000.  In addition, the owner took $33,927 in income tax deductions.  Depending on country/state laws and how tax experts prepared the filing, the owner is in a great financial position because (s)he spent $22,980 in real dollars to receive $30,000 income and is able to deduct expenses of almost $34,000 which is an advantage to the owner all the way around.  Depending on how the gains and deductions are taken, this situation could result in a double digit (11.7%) cash return on down payment (i.e. ($30k-$22,980)/$60k = 11.7%) or the above discussed $11,295 tax income savings which is an 18.83% return on the $60k downpayment.  Either way, the taxable income position of the owner has been advantaged significantly.

The purpose of the above example is to show that, unlike the S&P 500 Index in which all gains are taxed as income, the return on real estate is more than just an absolute 6.67% average annual gain. (Based upon the average selling price of houses over the last fifty (50) years).  The ability to realize the benefits of income tax deductions on real estate ownership is critical to recognize and include when considering the real return on a real estate investment. 

Please read Part III: Is Real Estate Really an Investment in which we examine the benefits of demographics and "The American Dream" on real estate return, summarize the entire research project, and make a final determination of which investment, (real esate or the S&P 500 Index), is better for long term investment return.