As a follow up to the last post, there is a point that needs clarification. First let me explain cash flow and how it may differ from the tax results. For example, suppose you own a rental property that provides a positive cash flow – rental income less all expenses – of $200/month. You might think that this would produce $2,400 of taxable income for the year. Actually this rental will most likely produce a “tax loss” on your return potentially offsetting any other taxable income that you may have. How is this possible? Depreciation.
Depreciation is the process by which you deduct a portion of the purchase price each year over a certain number of years (as defined by the IRS). For instance, residential rentals are generally depreciated over 27.5 years. A home with a depreciable basis of $275,000 would produce a $10,000 depreciation expense each year. Apply this to the example above and your rental property receives the best of both worlds – positive cash flow AND a tax loss!
As I mentioned last time, a financial decision must make economic sense first and tax sense second. In this case it makes both economic sense (positive cash flow) AND tax sense (tax loss). This may be a relatively simple point to analyze. I just felt the need to clarify the fact that real estate could produce a loss (tax) and still make sense to pursue.