If you buy real estate, and rent it out, you generally lose money, but only on paper. This diary talks about how this happens.
First of all, you buy real estate. The average person takes out a loan to do this, because real estate is expensive. So when you are a landlord, you have income, which is rents, and you have expenses, which are things like cleaning expenses, and utilities, and property taxes, management expense, that sort of thing. But with real estate (as with any business, but not as with consumer loans), you are also allowed to deduct interest expense that is paid to your bank. In addition to this, you are allowed to depreciate the value of your capital investment over time.
So the reason for this is that if you buy a capital asset, which is a thing that you use to produce income — piece of manufacturing equipment, or a car, or a computer or something — that thing usually has a limited life. A piece of factory equipment becomes obsolete eventually and has to be replace. If an asset — which is just something you use to produce income — has a useful life of more than one year, then you spread the total cost of the thing over the useful life of the asset. The IRS has some pretty strict rules on what the life of an asset is, and for real estate, the life of a piece of residential real estate is 27.5 years, and the life of a piece of commercial property is 39 years.
So for real estate, you basically get to deduct the expense of owning the real estate twice. Once for the interest you pay on the loan, for the term of the interest burden on the loan, and once on the depreciation of the asset itself (even though you don’t really own it, the bank does). So basically, if you are deducting your actual expenses on something twice, you are very unlikely to make money on it. That is how the real estate business works. The crazy thing about real estate is that it doesn’t actually become less valuable over time...typically its value actually increases.
In the 80’s a lot of tax shelters, which were later determined to be abusive, were basically just companies that bought real estate, and sold partnerships to investors who wanted to a piece of them because they wanted to harvest the losses to offset ordinary or investment income. They were doctors, or accountants, or other high earners who could afford to invest some money that they never expected to see returns on so that they could harvest some losses to offset their real ordinary income. After a while, the IRS closed these down. They created a new category for real estate gains and losses. Now real estate losses were “passive” losses. And the only way they could be offset (with certain ceilings for low-earners) would be if they were netted against “passive” (i.e. real estate) gains. The IRS said that unless you were a “Real Estate Professional”— i.e. a person who spent more than 50% of his time in the real estate business, you couldn’t offset your real estate losses against ordinary income — normal W-2 earnings, or earnings you made in your dog trimming business, or earnings you made as the star of a crappy reality TV show — or against investment income — interest, dividends, security sale capital gains.
But what if you *are* a real estate professional? What if you built Trump Tower in 1983? Say that Trump Tower is making a little money in rents after expenses, vacancy, overhead, and mortgage payments. Why is it making a little money? Well, if it weren’t, the bank wouldn’t have lent against it as an asset. Whys isn’t it making more money? Because this is Donald Trump, who probably takes out as much money against this asset as his banks will give him. So, the rents received for Trump Tower, less expenses and interest expenses, is a little bit positive every year. But in addition to this, we have to add depreciation to the mix. What if it cost 156 million dollars to build in 1983? Well, depreciated over 39 years, that’s $4 million dollars a year. That’s a paper loss that is fully offset against ordinary income — income from remainder sales of crap ghostwritten books, or payments from the Secret Service for plane rides, or golf course income.
So that’s how Donald Trump can make money and pay no taxes. However, he has to spend more than 50% of his time developing real estate.
So, America, are you ready for a part-time President?