J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

31.1 Real Estate Ventures

A real estate investment should provide a current income return and an appreciation in the value of the original investment. As an additional incentive, a real estate investment may in the early years of the investment return income subject to little or no tax. That may happen when depreciation and other expense deductions reduce taxable income without reducing the amount of cash available for distribution. This tax savings is temporary and limited by the terms and the amount of the mortgage debt on the property. Payments allocated to amortization of mortgage principal reduce the amount of cash available to investors without an offsetting tax deduction. Thus, the amount of tax-free return depends on the extent to which depreciation deductions exceed the amortization payments.

To provide a higher return of tax-free income, at least during the early years of its operations, a venture must obtain a constant payment mortgage that provides for the payment of fixed annual amounts that are allocated to continually decreasing amounts of interest and increasing amounts of amortization payments. Consequently, in the early years, a tax-free return of income is high while the amortization payments are low, but as the amortization payments increase, nontaxable income decreases. When this tax-free return has been substantially reduced, a partnership must refinance the mortgage to reduce the amortization payments and once again increase the tax-free return; see Examples ...