Article #4: Fourth "Element of Return" for RE Investors-Tax Shelter Benefits

Over the last three months we have discussed the first three elements of return for real estate investors and now we are ready for the fourth and final element, “Tax shelter benefits”.

Tax shelter benefits are the paper losses you can deduct from the taxable income you receive from the property. As an owner of an investment property, the IRS gives you an annual depreciation allowance to deduct against your income. The theory is that this deduction will be saved up and will be used to replace the structure at the end of its useful life.

To determine the depreciation allowance you can either reference the property tax bill or the appraisal you received when you purchased the property.

The tax bill is broken down into two components: (1) The assessed value of improvements (the structures on the land) and (2) The total assessed value of the entire property. By dividing the “assessed value of improvements” by the “total assessed value” you will calculate the percentage value of improvements. As an example, if our Boardwalk property’s tax bill assessed our value of improvements at $150,000 and our total assessed value is $200,000, then our percentage value of improvements is

$150,000 / $200,000 = 75%

*Don’t be alarmed if the actual dollar amount shown on the tax bill does not agree with what you are paying for the property; it is the ratio we are looking for.

The other document to consider is the most recent appraisal. In the section of the appraisal that covers the reproduction cost method, you should find the appraiser’s opinion of value for both the land and the improvements. The appraiser will estimate the cost to build the improvements as of the date of the appraisal. This is called the reproduction cost. By using the same formula as above we can calculate the percentage of improvements by dividing the “reproduction cost” by the “appraised value”.

Once you determine the percentage of improvements, we can then determine the annual depreciation allowance. Let’s go back to our Boardwalk property. Our Boardwalk property was purchased for $220,000 and if we use a 75% value of improvements are building represents a value of $165,000. We then use a straight-line depreciation method for residential investment properties as established by the IRS. In 1986, the IRS established the Modified Accelerated Cost Recovery System (MACRS) establishing the useful life of residential properties at 27.5 years. Therefore, we now divide $165,000 by 27.5 years to determine our annual depreciation allowance.

$165,000 / 27.5 = $6,000 annual depreciation allowance

Now that we know how much of a depreciation allowance we can get, let’s go back to our example to determine our overall tax shelter savings. Assuming a 28% federal tax bracket, we calculate the tax savings as follows:

Depreciation allowance: $6,000
Less cash flow -1,080
Les equity growth - 300
Tax Benefit: $4,620

The tax savings is calculated by multiplying the tax bracket by the shelter benefit as follows:

.28 X $4,620 = $1,293 tax savings

Congratulations, you’ve make it through a tough, but critical discussion to understand the total return available to us as real estate investors.

To wrap this up, let’s look at our total first year return on our investment combing the four elements of return. To recap, we have a cash flow of $1,080, equity growth from loan reduction of $300, equity growth from appreciation of $11,000, and tax savings benefits of $1,293.

Our total tax-deferred return on this investment is

Cash flow return $ 1,080
Equity growth (loan reduction) 300
Equity growth (appreciation) 11,000
Tax savings 1,293

TOTAL RETURN $13,673

We can then compute the total percentage return on the investment by dividing the first year return by the down payment ($30,000) as follows:

Total Return: $13,673 / $30,000 = 45.57% RETURN


I hope that you have enjoyed this information and I look forward to continuing our real estate investment conversations next month.

If you are interested in learning more about MONOPOLY 1, LLC and how our company can begin bringing these type of returns to your investment portfolio, please contact me.

Best regards,

BILL