Actually, there are two groups who might wanna consider this strategy. If your ordinary income (job) exceeds $150,000 annually, you can’t make use of any depreciation against that income whatsoever. Even those making $100,000 a year or less can use this approach if they find themselves with significant amounts of unused depreciation every year. The Internal Revenue Code puts a ceiling of $25,000 in annual depreciation that may be used to reduce your ordinary income. Many real estate investors have far more depreciation available than that figure.
If for whatever reason you find yourself in a ‘capital growth’ mode while the happy recipient of decent cash flow, consider periodically applying the lion’s share of it to your loan balance(s). If your interest rate is say, 6% or so, you’re beatin’ the bank’s alternative comin’ and goin’. Not only that, but the cash flow was sheltered from the get go. Every dollar of principal paid off is a dollar on which you’re not gonna pay 6%. At the end of the year you’re not taxed on it either. It’s not even a taxable event at that point. You win.
But wait, there’s more.
Because you have accumulated so much unused depreciation (tax shelter), when it’s time to sell and move up, you’ll have a good news/better news ending. The good news is you’ve created a whole bunch of extra sales proceeds due to having applied so much cash flow over the past X number of years to your loan balance. The better news is, that extra cash can be mostly if not entirely sheltered by all the unused depreciation you’ll now pull off the shelf.
Here’s an example of how it would work.
You bought a $400,000 income property several years ago. It hasn’t appreciated much, just a little in fact, but it’s rents have increased to the point it’s been yielding roughly $8,000 a year in cash flow. Let’s say for five years you apply $6,000/yr of your cash flow against the principal. Here’s your loan picture at the end of those five years.
First, we’ll pick a starting balance. We’ll say the loan began at $320,000 seven years ago. That means your current balance is about $286,850. Five years from now that balance will have dropped to roughly $253,050.
If the payments were increased by the above suggested $6,000 — paid monthly in $500 principal payments — here’s what would happen. Your balance would’ve dropped, in the same five years, to around $217,100. That’s a gain in equity just short of $40,000 — using cash flow you didn’t need in the first place.
If you’d kept the $6,000 a year for those five years, you’d have made 2-4% before taxes, and before any potential inflation. In other words, this strategy allowed you to earn 6% interest on your cash flow, and you will, more likely than not, never pay taxes on it. In better times, which we will live to enjoy again, that can mean the ability to acquire more property than if you hadn’t executed the strategy.
Anywho, something for you to consider.
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