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How the Wealthy Use Phantom Expenses

Yes, it is I who has plundered and modified the great words spoken in the Phantom of the

Opera, written by Gaston Leroux. I replaced the word “music” with “real estate” to make

jest and have fun with this article.


Real estate is very much like music in the sense that to achieve harmony, all the instruments must play together with perfect timing. Today, the instrument we are discussing is depreciation.


Simply put, depreciation allows you to write off the buildings and improvements over a prescribed period of time, providing a “phantom expense” that is used to offset rental income.


This is possibly the most overlooked benefit of owning real estate. Rookie investors

boast all day about their property appreciating, while the pro’s talk about depreciation

tactics. Think of this... in real estate you can earn tax deductions on an asset that is going

up in value! That’s the only investment I know of that provides this benefit.


So how does it work?


The IRS allows a deduction for the decrease in value of your property over time. A

commercial property “and improvements” are depreciated over 39 years. Also, much of the

acquisition costs (legal fees, recording fees, surveys, transfer taxes, title insurance) and any

amount the seller owes that you agree to pay (such as back taxes) can be included in the

basis.


Basically, you separate the building value from the land value (since only buildings

depreciate), then you divide by 39 years. It is a little more work than that, but that

provides a simple explanation.


This depreciation calculator will help do a lot of the math for you. Be sure to separate the value of the building from the value of the land.

Be sure you start with the assessed value, which you can find on your county property appraisers website.


For those of you who prefer examples:


Let’s say you buy a commercial building for $500,000. The tax assessor’s

estimate of the land value is $125,000, and the building value estimate is $375,000.

Your depreciation expense that you take each year against rental income would be

$375,000 divided by the IRS allowed 39 years of useful life (commercial real estate) for

a depreciation expense each year of $9,615.


So thanks to that depreciation expense, you are saving $9,615 multiplied by your marginal tax rate (which is a topic for another day). This could be tax savings of approximately $2,000 per year, just for the depreciation amount.


When playing with the "Phantom"

When playing with the “Phantom” remember that there is also phantom income, which is

taxable income the IRS uses to charge you for things - such as the principal portion of your

mortgage.


Real estate investors who want to maximize their after tax cash flow need to be

cognizant of phantom income and compare their cash flow to taxable income. It’s a fine

line to walk, but with proper analysis from a CPA, you will have the opportunity to create

more leverage on your investment properties.


To truly maximize the benefits of commercial real estate, it is important to understand the way your money flows.


Feel free to connect with one of our trusted Advisors to learn more.