Wouldn't it be nice if you could get a tax deduction for something you didn't pay for? Well, guess what… You can! (Bet you didn't see that coming) What is this sorcery and how is it possible?
Leverage is the use of borrowed money to invest. As you can imagine, leveraged capital can be used to fund a variety of different investments; for purposes of this article, however, we're going to focus on utilizing leverage when investing in real estate.
Using Other People's Money
If you've ever purchased a home (personal or investment) with a mortgage, you've used leverage. You've used other people's money (OPM) to finance a portion of the purchase.
For example, if you bought an investment property for $300,000 and put 20% down, you leveraged $240,000 ($300,000 x 80%). In other words, you now fully own a property worth $300,000 but only paid $60,000 ($300,000 x 20%) out of your own pocket.
There are other ways to use OPM in real estate in addition to a traditional mortgage (hard money, home equity loan, HELOC, a loan from a friend or family member, etc.) but the concept is the same – purchase and own the whole property but only pay for a portion of it yourself.
The Major Tax Benefits of Using Leverage
It's no secret that I love depreciation. Since you're not allowed to deduct the purchase of an investment property as an expense, the IRS allows you to recover that cost over a predefined period of time due to wear and tear on the property via depreciation.
Residential real estate is depreciated over 27.5 years and commercial real estate is depreciated over 39 years.
So, how does this relate to leverage?
The IRS allows you to use 100% of the property’s basis (excluding the value apportioned to land) to calculate depreciation, even if you used borrowed funds to buy it. That's right – you can deduct 100% of the depreciation expense even if you financed a majority of the purchase using OPM.
Let's run through an example with some numbers…
Let’s assume you purchased a residential rental property for $350,000. You put 20% down ($70,000) and financed the remaining 80% ($280,000). The allocation of the basis to the building is $275,000. Remember, land is not depreciable. The class life of residential real property is 27.5, meaning the depreciation deduction you are entitled to is $10,000 ($275,000 basis over 27.5 years) per year.
In other words, you’re receiving the benefit of an annual $10,000 tax deduction—computed on the full amount of the property’s depreciable basis—for the next 27.5 years even though you only used $70,000 of your own money to buy the rental property.
As a result, depreciation often wipes out most, if not all, of the taxable net rental income, generating “tax-free” cash flow. There are certain limitations on the ability to deduct rental losses if your depreciation expense exceeds your net rental income before depreciation, however.
An added tax benefit to using OPM is that the interest you’re paying on the borrowed funds is 100% deductible (unless you’re owner-occupying a multi-family property) against rental income.
And the cherry on top is that the rental income from your tenant(s) will (hopefully) cover the cost of the debt service, which essentially means they are paying your loan back while you still reap the benefits of the tax deductions.
Pretty sweet, huh?
Leverage can increase your buying power. What exactly does that mean?
Assume you have $100,000 in the bank and you wanted to use it to invest in real estate. If you do not use leverage, you can buy one property for $100,000, all cash. If you use OPM in conjunction with your own, however, you can buy multiple properties or a more expensive property with the same amount of cash. For example, you can buy five properties, each worth $100,000, by putting down 20% on each property and financing the rest. You could also purchase a $500,000 property using the $100,000 as a 20% down payment.
The beauty of leverage is also evidenced when calculating your rates of return.
For example, if you purchase one property worth $100,000 that generates cash flow of $9,000 per year, you’re earning 9% on your money ($9,000 / $100,000). If you purchase that same property with 20% down and an $80,000 mortgage, you’d have less cash flow due to the monthly cost of the mortgage (principal and interest), but your return on investment (ROI) would be higher. Let’s assume the annual cash flow would be $4,000. This means you would be earning 20% on your money ($4,000 / $20,000).
As you can see, the same exact property yields more than double the ROI in the above examples just by using leverage.
Of course, there are risks associated with borrowing money to invest. There is such a thing as being over-leveraged. Fluctuations in the market can cause highly-leveraged properties to be worth less than the amount of debt secured by the property.
Both consistent and rapid declines in market value can lead to significant losses in equity. Remember, you still own 100% of the property despite using OPM to finance a bulk of the purchase. If the market dips, so does your equity, but the outstanding loan balance remains the same.
Declines in the rental market could place a property under water, as well. If conditions in the area in which your property is located cause the average rent prices to decrease, your monthly rental income may not be enough to cover your expenses and the debt service. While the interest and depreciation expenses are still tax deductible, finding yourself in a negative cash flow situation can be detrimental if you have to start depleting your reserves to cover the shortfall for an extended period of time.
It’s extremely important to do extensive market research on the areas in which you are planning to invest. Steady population and job growth are good indicators of future appreciation of home values and increases in rental income.
To Sum Up…
Leverage allows you to:
- Deduct 100% of the depreciation you’re entitled to, even if you use OPM to finance the
- Deduct 100% of the interest payments on the loan against rental income.
- Use your tenants’ money to repay the loan while still claiming the tax deductions on your
(or your entity’s) tax return.
- Buy more or more expensive properties with the same amount of money.
- Achieve higher rates of return.
But there are also risks associated with using leverage; like anything else, due diligence should be done before investing using OPM. If you’re thinking of buying an investment property with borrowed money, refinancing a current loan, or tapping into the equity of a property you currently own, be sure to discuss the advantages and disadvantages of using leverage with your CPA before making any moves (both literally and figuratively).