Don’t buy real estate just for a tax write-off

Question: Now that prices have dropped so much, my husband and I would like to purchase some real estate for tax write-off purposes. Should we purchase a small condo locally, or acreage east of the mountains, which we would use for recreation?

We’d really like to purchase property in Eastern Washington, but we were told by a friend that unless the property was our primary residence, we could not take tax deductions. Is this correct, and if so, how would this affect a rental condominium?

Answer: Your friend is incorrect. You can deduct mortgage interest expense and property taxes on a second home or rental property, just as you can deduct the interest expense and property taxes on your primary residence.

If you purchase raw land in Eastern Washington, it could be considered “investment property,” and you would also be allowed to deduct the mortgage interest and property taxes. If you purchase a condo to use as a rental property, you could deduct the homeowners association dues, insurance, utilities, repairs and depreciation, in addition to the property taxes and mortgage interest expense. In other words, you can generate a bigger “tax loss” from rental property.

However, as I have written before in this column, I don’t recommend buying real estate just for “tax write-off purposes.” Tax laws change, and profitable investments based on current tax laws can turn into money-losing sinkholes if the government decides to change tax policy.

A classic example of this occurred in the 1980s. Real estate tax shelter investments were set up to cash in on the new accelerated depreciation rules that took effect with the 1981 tax reform act. The shelters were very profitable, for a while. Then came the 1986 Tax Reform Act, which wiped out all the tax benefits of the shelters and turned them into big money-losers for the investors.

I believe that your primary objective in buying rental property should be to make money, not lose money. At worst, you should have a break-even cash flow going in.

I’ve never understood the obsession that some people have with generating tax losses. If you’re in the 28 percent income tax bracket, you reduce your income tax bill by 28 cents for every dollar of tax loss, but you still have to pay the other 72 cents out of your own pocket. Any way you look at it you’re losing money.

Many investors consider depreciation to be only a “paper loss” because they are allowed to deduct a portion of the property’s value each year even though they don’t actually have to write a check for that amount. But when the property is sold, the depreciated value creates a taxable “gain” for the investor, even it is sold for the same price that they originally paid for the property.

For example, let’s say you buy a $250,000 condominium. The IRS allows you to depreciate the property over 27 years. That means you get to deduct 1/27th of the property’s value from your income each year. In this example, you would deduct $9,259 per year.

After five years, you will have “depreciated” your $250,000 property by $46,296 (5 x $9,259) to a reduced tax basis of $203,704. If you then sold the condo for $250,000 — the same price you originally paid for it — you would have a $46,296 taxable “gain” on which you would have to pay capital gains tax. So you can see that depreciation is more than just a “paper” expense.

If you decide to buy land, buy it for its recreational use. Never try to convince yourself that you are buying recreational land as an “investment.” Buy it for fun. If you happen to make a profit when you sell in the future, that’s just icing on the cake.

The market for recreational property is very volatile. Some years it is hot, other years you can’t give it away. It’s quite likely that you would lose money if you had to sell the land in a slow market, if you could sell it at all.

In deciding between buying a local rental condominium or recreational land, focus on your primary goal. Do you want to make money, or are you just looking for a place to go have fun?

Rental property produces income and literally pays for itself over time. Raw land is just an expense. It may pay for itself if it appreciates in value, but don’t bet on it.

My personal preference is for rental property because I like property that produces income instead of just sitting there. But there is nothing wrong with buying raw land, as long as you understand what you’re doing. If you can legally put a mobile home on the land, that is an excellent way to generate some rental income while you’re holding the property.

Real estate investors call this “land banking.” If and when you decide to build a permanent home on the land, you simply sell the mobile home and move it off the property.

Steve Tytler is a licensed real estate broker and owner of Best Mortgage. You can email him at features@heraldnet.com.