Sometimes we’re so close to something day to day that a question can get us doin’ the RCA Dog impression without warning. One such question is probably one asked of me the other day — which I thought might be on more than just her mind. She asked,
“When you say the ‘after tax’ cash flow is $X, what gets taxed, and is it like my paycheck’s ‘after tax’ sadness?”
Well, sometimes it’s the same. For many however, the after tax cash flow is actually greater than the before tax cash flow.
How can this happen?
Paradoxically, when your after tax cash flow is higher, it’s due, the vast majority of the time, to a loss. It’s a paper loss to be sure, but a loss nonetheless. In this case it’s what’s called ‘depreciation’. Simply put, depreciation is the IRS agreeing that buildings and many of the things inside them, even things appurtenant to the land, ‘depreciate’ in value over time. In other words, they wear out.
Thing is, you don’t really experience a financial loss, it’s only on paper. When you file your tax return your tax preparer will include a figure for depreciation. It’ll be on Schedule E. Again, it’s only a paper loss — you didn’t lose a nickel.
However, since your cash flow was say, $9,000 and your depreciation was $29,000, the cash flow itself isn’t taxed. It appears as if you had no cash flow on the return — in fact, you lost money. But not really.
But wait, there’s more! What happens to the extra $20,000 of depreciation?
So glad you asked. That amount, as long as your ordinary income is $110,000 or less, can be applied as a loss against that income. By the way, ordinary income = job income in IRS-speak. I say $110,000 or less cuz the IRS begins phasing out the real estate investor’s ability to make use of depreciation ($25,000 max a year against personal income.) once their ordinary income edges over $100,000. Once you reach $150,000 you’re outa luck Chuck. No depreciation can be used against your ordinary income. (Don’t ask, it’s a whole nuther post. 
) So if you had $20,000 in applicable income and made no more than $110,000 at work, you’re probably good to go.
BawldGuy Caveat: Look, been doin’ this for decades and know what I’m talkin’ about. But seriously? Don’t believe me, believe your own qualified tax preparer. Better yet? Give very experienced CPA, Charles Perkins a call and tell him I sent ya.
What that means in language you and I speak, is that if your income was $76,000 that year, the $20,000 depreciation ‘loss’ now magically makes it $56,000 before you even start fillin’ out the return. In terms of your taxes, here’s the payoff. Counting Fed/State taxes, and oversimplifying things, if your combined marginal personal tax rate (state & fed) is 25% — you just saved $5,000 in taxes.
Here’s Before — Here’s After
So your before tax cash flow is $9,000. But your after tax cash flow, due to the $20,000 ‘loss’ applied to your job income, is now $14,000.
$9,000 in actual cash flow + $5,000 tax savings = $14,000 in after tax cash flow.
And now ya know. Make sense?
Know what really makes sense? Givin’ me a call at 619 889-7100 to talk about what our retirement is gonna look like. Is it lookin’ as good as it should so far? No? Helllo? Dial. Or send me a not via the Contact BawldGuy button up top. Have a good one.
Related posts:
- What a Little Well Placed Cash Flow Can Accomplish
- When Is Chasing Cash Flow Inappropriate?
- Understanding What’s Important — It’s Usually Not a Bunch of Cash Flow
- The Good Old Days — Negative Cash Flow Sometimes Golden
- Real Estate Investors — Is Your Addiction To Cash Flow Lowering Potential Retirement Income?
About BawldGuy
What are the tax advantages of holding real estate for individuals with W2 income over $150k?
Hey Chris – Actually that’s an exceptionally insightful question. I’ll be answering it in a post next week. It’ll include the answer to your question and deliver multiple strategies executed synergistically which will take advantage of those noted in your question.
The bottom line for W2 earners makin’ more than $150K? They might find themselves in even better position than those earning under the $100K cap. Yup, another tax related paradox.
Thanks Chris.
Thanks for another good one.
Thanks Aunty — call me when you get a chance this week.
BawldGuy, as you suggested, better leave taxes to the experts. There is a dark side to rejoicing about increased cash flow from tax “savings” due to depreciation you did not disclose: taxes are not actually saved. They are deferred until the sale of the asset, at which time tax will have to be paid on what at the time of sale will seem like phantom income, i.e. a paper profit but real money taxes. Yes, there may be some benefit of conversion from ordinary income to capital gains, but the deferred tax will have to be paid even if there is no “real” profit from a sale. A very unpleasant surprise for many. BTW, I am no tax expert – just the voice of experience…
Hey Peter — First of all, when you come into my house, treat me with respect or be gone.
Voice of experience? Gimme a break. I can break down your comment in any number of ways, but don’t have time for a post-long comment. Suffice to say, all you’ve said is that water is wet, and grass is green.
The only time any of what you speak of is a surprise is when amateurs are in charge. Hardly the case here. There are strategies which have been discussed on these pages numerous times which address what your experience has taught you. Only a fool or an ignoramus would simply sell and pay capital gains tax, deferred or not, without either an astoundingly good reason, or during a financial emergency.
What if I told you there have been many, many clients who’ve sold for significantly large profits and paid absolutely no capital gains taxes OR recapture taxes?
If selling or not selling are the only options on your menu, you need a new menu.
The BawldGuy makes an excellent point. There are a number of options available that can lead to no tax or reduced tax when an investor decides to dispose of a property.