All right, welcome! Today, we’re going to talk about real estate taxes. Most people understand that real estate provides certain tax benefits, but very few people understand what those tax benefits actually equate to and how it works. I’ve talked to CPAs, bookkeepers, and real estate investors, and almost no one can explain it in a simple way that I can understand. So, I had an idea. I went to my friend ChatGPT to get the question answered in a simple way as possible.
Here’s the scenario: I have an $800,000 house in San Diego that I’ve rented all year for $3,200 a month, and my expenses were $3,700 per month. How much can I deduct from my income taxes as a loss, and how much money does that save me?
ChatGPT explained it to me like I’m a fourth grader. Since I’m charging $3,200 a month, we’ll multiply that by 12. That gives us $38,400. Brilliant! We’ve lost $6,000, but in the US, Uncle Sam lets you write that loss off of your income. Love it! This helps lower the amount of money the government is going to say that you owe them at the end of the year. But exactly how much does this save? It’s a bit harder because it depends on your tax bracket. Let’s say you’re in a 24% tax bracket. You’re able to deduct the $6,000 loss times 24%, which would equal about $1,440. So, you would save $1,440 on your taxes.
Now, let’s add in the state depreciation. In California, in addition to the $1,440 I saved from my federal taxes, it will save me about $480 cash on my state taxes. And then there’s depreciation. Over 27 and a half years, I can depreciate the cost of the house. Let’s say it’s 80% of the total cost of the property. That’s equal to about $23,273 in yearly depreciation. Applying the federal tax rate of 24% to the depreciation, that’s $5,586. And with the 8% state tax rate, you’d save another $1,862. So, according to ChatGPT, we have $1,440 in federal taxes saved, $5,586 from depreciation, $480 in state taxes, and $1,862 from depreciation. So far, we’re at $9,368 in total tax savings.
But wait, there’s more! I’m in California too, and it can get a little dicey over here. They’re asking for a lot of money. In California, in addition to the $9,368, I saved from my federal and state taxes, the appreciation of the property is another big benefit. Let’s assume a 30-year loan and a 3% appreciation rate. At the end of five years, at 3% appreciation per year, the house is worth $920,000. That’s gone up $128,000 in five years.
Now, let’s talk about amortization. It means you’re paying off the debt over time. And what about the principal paydown? Let’s say you rented the house for two years and had a $600,000 loan at a 3.5% interest rate. After the second year, you would have paid off approximately $21,000 of principal. So, adding up the principal paydown, tax savings, appreciation, and depreciation, your property investment may have made you $88,536 over the course of two years.
But wait, I was losing $6,000! Well, now you know. After everything’s taken into account, you’re likely ahead by about $3,368. This doesn’t necessarily mean you have that in cash, but it means you avoided that in taxes, which helps soften the blow. So, there you have it. ChatGPT explained a very simple thing at a fourth-grade level that I can understand. Hopefully, you understand it a little better today. Good luck with your investment!
