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| The Basics | Get more income from your real estate
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You can't depreciate the land beneath your rental, but with a little creativity, you can get a tax deduction from it. Also: Rent your house out tax free.
By Jeff Schnepper
Real estate was the No. 1 investment last year and seems to be just as hot this year. But investing in real estate is complicated. And, worse, theres a lot of bad information out there.
I have received lots of questions here at MSN Money both via mail and through the MSN Money Tax Corner community.
Here are answers to two of the questions Ive received:
You can't depreciate land -- usually
Hey Jeff: I just bought a duplex that I plan to rent out. My accountant says that I can depreciate the cost of the building -- but not the land. Thats not fair! Is he right?
Answer: Yes -- and no. Technically, only the cost of the building is subject to depreciation. You depreciate residential real estate over 27.5 years on a straight-line basis. Thats 3.636% per year for a full year.
But lets get creative. Assume your duplex cost $133,000, with $33,000 of the value allocated to the land. The IRS allows you to depreciate the $100,000 cost for the building -- or $3,636 a year -- but, as your accountant noted, nothing for the land.
Can we find a way to deduct the land? Heres an idea Ive used with real estate Ive owned. I set up a trust with my three kids as beneficiaries. I then deed the land only to that trust. Since I have three kids, their $11,000 annual gift-tax exclusion eliminates any gift-tax issues. I asked my friend Jimmy to be trustee.
But Jimmy now has a problem. He has a fiduciary duty to the beneficiaries -- my kids. The trust's land has my building on it. So, Jimmy gives me the bad news.
Jeff, he says, your building is on the trusts land. You can remove the building, or you can pay the trust a lease rental for the use of the land.
Assume the lease rental is $400 per month, or $4,800 per year. Since thats a legitimate rental expense -- it's really hard to rent a property with no land beneath it! -- its deductible to me at my marginal tax rate. If Im in the 28% federal bracket, that saves me $1,344 in tax.
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Each of my kids is taxed on $1,600 per year. The first $800 is taxed at zero and the next $800 at their marginal rate, 10%. Thats $80 per child or a total of $240 per year. Thats a savings of $1,104 ($1,344 - $240) each year. Over a 15-year period, thats a savings of $16,560 in federal taxes alone. Any state tax difference is a bonus.
Thats how Id depreciate the land. One last point before you rush off to see your lawyer. My example assumes no costs for setting up the trust. That will cost some money and additional paperwork every year.
How to get a little extra from a second home
Hey Jeff: I have a second home on the Jersey shore. Since its waterfront property, it cost me a fortune. If I rent it out to generate a little cash for paying my mortgage, do I have to report the income?
Answer: Once again, the answer is yes -- and no.
Heres the general rule. Youre taxed on all income unless theres a specific exclusion. With real-estate rentals, there is a special exclusion.
A unique provision of our tax code excludes any income generated from the renting of real estate for less than 15 days during a calendar year. So, if you only rent it out for 14 days, the cash you get is tax free.
This applies to income generated from a second home or even your principal residence. The only limitation is that it be rented out for less than 15 days. Once you rent it out for the 15th day, ALL the income you've generated from the property becomes taxable.
Lets get creative.
Assume you have a Subchapter S corporation. Thats one where the net income is passed through directly to you as the owner.
Theres no reason why you cant have a business meeting at your primary or second home. You need a business purpose for the meeting. But that should be simple. A legitimate corporation should have no problem finding a business purpose for the meeting. Its done all the time.
Find out what it would cost to have the meeting at a local hotel. Thats the price you charge the corporation. Assume thats $500 per day.
If you have a business meeting once a month at your house (12 is less than 15), then youve got $6,000 in tax-free income from the corporation. But, were not done yet. Remember, the business meetings are a legitimate business expense. That means that the $6,000 paid is deductible to the corporation and therefore to you personally.
If youre in the 28% bracket, that saves you $1,680 in tax. Combine that with $6,000 in tax-free income, and it's not a bad deal.
But, were still not done.
What if you dont have a Subchapter S corporation? Are you charitably inclined?
How about renting your house to your church or synagogue each month for their board meetings? Lets run some numbers.
Assume you rent the property (less than 15 days) for $5,000 over the year. Thats $5,000 in tax-free income.
You then contribute $6,000 to the charitable organization. The charity now had the use of your property and is up $1,000.
You get to deduct the $6,000. If youre in the 25% bracket, that contribution saves you $1,500 in tax. Combine that with the $5,000 in tax-free income and youre up $500 ($5,000 plus $1,500 in tax savings) even after making the $6,000 contribution.
The 14-day rule applies to each property. So, if you have two homes -- a primary and a vacation home -- you can rent each out for 14 days, tax free. Not a bad deal.
A note on tax reform
My column "7 big tax changes I'd really like to see" generated hundreds of e-mails and more than 290 comments in Tax Corner. Check out the conversation here.
Stay in touch. I'm going to be talking about tax reform a lot this year.
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