BY TOM WHEELWRIGHT
All governments use the tax law to encourage investing and other activities. They want to encourage business development and growth so they give businesses tax deductions for their expenses. They want to encourage research and development, so they give extra deductions and/or credits for increasing research and development. In South Africa, for example, businesses receive a deduction equal to as much as 150% of the research expenditures. They want to encourage individuals to have and take care of children so they routinely give tax deductions and credits for children and education.
The biggest tax benefits are reserved for real estate investors. Worldwide, investment in real estate, particularly in new developments, receive the single biggest tax benefit available commonly called depreciation or cost recovery deductions. Most people, when they invest in real estate expect the real estate to appreciate. While there is some wear and tear, they expect the real estate to last for many, many years and continue to increase in value.
Despite the obvious increases in value from good development, real estate investors commonly receive a deduction against their taxable income as if the real estate were actually going down in value. This incentive is called depreciation or cost recovery. Here’s an example of how it works.
An investor decides to buy land and build a new apartment or office building. The building costs $1 million to build. The investor makes a down payment of $250,000 and borrows the rest from a bank. Once the building is placed in service, the investor can begin taking a depreciation or cost recovery deduction. This deduction can range from $25,000/year (40 year depreciation) to as much as $300,000 in the first year (100% for certain property, such as the contents of the building and land improvements). In the latter case, the investor is receiving a deduction in the first year for more than their entire down payment. The bank doesn’t receive the tax benefit from depreciation; that’s reserved for the investor.
There are other tax benefits as well. Some countries allow investors to postpone any gain when they sell the property if they buy another property. Certain countries have additional tax benefits for building in distressed areas, often called opportunity zones or economic development zones. In these cases, the gain from sale of the building may be entirely eliminated rather than merely postponed. Many countries give tax credits for developing low-income housing or for rehabilitating historic structures.
The United States now gives major depreciation benefits for acquisitions of used property as well. A rental property in the U.S. can be depreciated over and over again by each new buyer.
The goal of these tax benefits is to encourage real estate investing, especially in new developments. Most real estate investors are aware of the great benefits from using debt (leverage) to buy and develop real estate, They may not realize that they are not just leveraging their cash-on-cash returns when they borrow to build, they are also leveraging their tax benefits.
Tom Wheelwright is a CPA based in Phoenix, AZ, USA. He is a best-selling author of Tax Free Wealth