From first looks, the long-awaited package to support the real estate sector, cleared by the Cabinet on Wednesday, appears well-designed. The ₹25,000 crore

What does Robert Kiyosaki mean by the phrase ‘sheltering income through real estate’?

When you report the income and expenses for rental properties on Schedule E, you will list the income you collected, along with your operating expenses: property tax, mortgage interest, insurance, repairs, maintenance and replacements for starters.

You will also have a space for “depreciation.” The term refers to the “reduction in value of an asset over time, especially to wear and tear.” In other words, the improvement on the land (the building) is wearing out a little every year. There will come a time when theoretically is will be worth zero.

For residential property, the IRS allows you to depreciate the building (but not the land) over a 27.5 year schedule. A property whose improvement is worth $275,000, for example, will depreciate at $10,000 each year (275,000 / 27.5 = 10,000).

Let’s say you’re able to collect $2,200 per month rent on your rental house, and that your mortgage payment (P&I) is $1,074. There are other expenses, which I’ve listed below:

You’d have $541 per month in your pocket in this example. Normally, you pay income tax on money you make, as from your employment. But when we look at what you report on your income tax return, you get a different picture:

Even though you’re not able to deduct the entire mortgage payment (part of it goes to pay down the principal balance), you’ll notice that your tax return is showing a negative number. That will typically reduce the other income on which you have to pay taxes. This is because of the magic of depreciation. Even though you pocketed $541 each month, it didn’t create a current tax liability. The $10,000 you claimed in depreciation was a non-cash expenditure—a “paper loss” that more than offset the money you collected during the year.

There is a minor catch to this, however. To understand this, you have to know about “cost basis.” Here is a slightly oversimplified explanation (talk to your tax person for all the details):

When you buy an investment asset, what you pay for it is the “cost basis.” Your basis will be adjusted up or down by several different factors. When you sell it, your “recognized gain” will be the difference between the adjusted cost basis and the sales price. So if your adjusted cost basis for an asset is $200,000 and you sell it for $300,000, your gain will be $100,000. That’s what you’d typically pay tax on.

As you claim depreciation, your cost basis will go down by the amount you claim. If you’re claiming $10,000 per year and you sell the property after five full years, you will have reduced your cost basis by $50,000. If you paid $300,000 for a property, claimed $50,000 depreciation over a five year period, then sold if for $400,000, your recognized gain would be $150,000 (400,000 – 300,000 – 50,000 = 150,000).

There are two “tricks” involved potentially: one, that the depreciation on the property sheltered income you received and would have paid ordinary income rates on. If you are liable for capital gains tax, it may be at a much lower rate than your ordinary income rate.

The second “trick” is that you can defer the gain indefinitely by executing a tax-deferred exchange into another like-kind property, rather than selling the property outright. Explaining how an exchange works is beyond the scope of this simple explanation, but if you search on “1031 exchange,” you’ll find plenty of information. Or, for that matter, you could just ask a separate question.

I hope this is useful—and understandable!