In the article How I Achieved 20% Annual Return By Taking Mortgage Debts, I showed by using simple math that one can achieve about 20% return on investment, an spectacular return. But that is not the primary reason why I got into rental properties back in 2004.
I bought my rental properties because I wanted to “manufacture” some capital gain, so that I could take advantage of the capital losses I had incurred up to that point.
So what is “capital gain”? You may ask. According to Wikipedia.org, capital gain is:
“the profit realized on the sale of a non-inventory asset that was purchased at a cost amount that was lower than the amount realized on the sale. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property.”
So when one buys houses or stocks at lower prices and sells them at higher prices, he realizes capital gains. Unfortunately, up to 2004, Even though I was more ten years into investing in stocks and all I had achieved was the opposite of capital gains – capital losses. My investment performance have got remarkably better since then (I will brag about it in a future article, I promise), but up to that time, I had realized about $120,000 capital loss.
Unlike Scott Mitchell, I did not lose money through day trading. I hold an advanced degree in Electrical Engineering and was working for a telecommunication company, so I thought I had some advantages in high tech area and indeed I lost good money by investing in high-tech companies. There is really more than one way to lose money in the stock markets.
As opposed to capital gain, the income one typically earns through wages, salaries, tips, interest, dividends, etc., is called “Ordinary Income”. No if I could deduct the capital losses from my ordinary income so I could pay less tax on, I would have had an easy time to swallow the losses. The IRS rule dictates that unless I can realize some capital gain, the only way I can take advantage of the huge capital loss is to deduct $3,000 each year from my ordinary income.
Congratulation to me! Through my not-so-insightful stock investing, back in 2004, I had accumulated about 40 years worth of deduction. Honestly I did not think I would physically last that long. Plus there is a time value of money factor here: $3,000 I could deduct 40 years from now worth a lot less than $3,000 in 2004. (I obtained an MBA degree in 2004 and they taught me stuff like “time value of money”. Cool stuff).
So I decided to do something. My solution was real estate.
I was not speculating the real estate value in Texas was shooting up like that everywhere else was. Thanks to the high property tax rates and unlimited availability of land in our state, real estate value here has appreciated at a rate slightly lower than inflation. No, my device of creating capital gain does not depend on the property price appreciation. Even if the prices stayed unchanged, I could still produce a sizeable capital gain after holding the property for a couple years.
You see, there is another strange IRS rule (they are all kind of strange, aren’t they?) that allows me to “depreciate” the value of the houses and claim the depreciation as expenses each year. Specifically, IRS considers each year my houses worth exactly 1 over 27.5 less than the last year, and allows me to claim that as expenses, deducting that from the rent income so I pay a little less tax.
Actually, quite a bit less tax: for a $100K house, the depreciation expense is $100,000/27.5=$3636 each year and I can deduct the full $3636 from my rent income. As told, the rent income is around $12,000 per year.
Understand this not a cash expense, or in another word, I do not have to take money out my pocket to pay for it. And the marvelous thing is, my houses do not necessarily lose value each year. Chances are, I can sell the house at prices higher than my purchase price. Why not?
Thank you, IRS! You can be a friend sometimes
Now each year, the purchase price minus the accumulated depreciation becomes my new cost basis of the house. If I ever sell the house at a price higher than the cost basis, better yet, higher than the purchase price, I realize a capital gain.
For example, it has been almost 8 years since I bought my first house at around $100,000. In the past 8 years, I have claimed depreciation expenses of $3636 eight times. The accumulated depreciation is $3636 x 8 = $29,088. Even if I sell the house today at $100,000, I will be realizing a capital gain of $29,088.
And that is just one house. When I combined 4 to 5 of this little babies together, I managed to “manufacture” some capital gain and would be able to take full advantage of my capital losses, if only they have not been claimed for.
Accidentally I have been rather successful in stock investing during the past 8 years, and the capital losses have long been appreciated.
And that is another story, which I will tell in future.