How To Reduce Tax With Japanese Real Estate Investment

One question that will never cease to be topical is “How can I reduce my income tax burden in Japan“, using Japanese real estate depreciation.   As reiterated multiple times throughout our Insights Series, and in person with clients, it is imperative to be tax aware with investment decisions; but also to avoid becoming tax driven with investment decisions.

Tax aware – making an investment decision based on the object risk / reward tradeoff; with any potential tax benefits being treated as just one of many criteria

Tax driven – making an investment decision solely or primarily on a potential tax benefit, with the potential investment value being small or outright insufficient to compensate the investor for whatever risks being taken.

A popular tax-reduction strategy among foreigners in Japan involves purchasing real estate and then using depreciation and other annual deductions to reduce their annual tax burden. This is a good example of an investment decision that can go fantastically well, or fantastically wrong.

So what is depreciation and how does it work with property?

Depreciation – A declaration that an asset you possess is losing its value, bit by bit each year. For some assets, the government will allow you declare this “loss”, and accordingly reduce your annual income taxes.

In short, when you buy a property, the government splits the appraisal value into the land value and the building value. Further, within the building value, part is deemed to be the structure (concrete, steel framing, etc.) and part is deemed to be the components within the building (copper electric wires, gas lines, etc.). Each of which are depreciated at different rates.

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Example Purchase:

An apartment in Meguro for 22,000,000 JPY

12,000,000 JPY is attributed to your apartment’s share of the land that the apartment building rests on

10,000,000 JPY is attributed to the actual apartment

From the above 10,000,000 JPY:

Structure – 7,000,000

Wiring etc. – 3,000,000

From here is where things can get a bit complicated. (many would argue that it is purposefully kept complicated, and further complicated each year, in order to keep accountants in business; but that’s a different discussion…)

Depending on the composition of the structure and how old the apartment is, the government will let you depreciate a fixed % of the structure each year. The wiring etc. are also depreciated at a different rate, often much faster.

To simplify, and skip ahead of the complicated accounting laws/regulations, let’s assume that you are able to straight-line depreciate the value of the structure down to zero over the course of 20 years, and the wiring down to zero over 10 years.

7,000,000 / 20 = 350,000 per year

3,000,000 / 10 = 300,000 per year

This would indicate that you could declare a depreciation loss of 650,000 JPY total each year from this apartment. At 50% top tax rate that means you could rebate 325,000 JPY this year in taxes. At 30% tax rate you would receive a rebate of 195,000 JPY.

low cost japanese real estate investments

Add to this the fact that you could deduct as “property management expenses” a certain amount of traveling around the area, as well as “business” lunches and dinners, etc; and you are looking at a decent amount of tax rebates each year.

However; there is another side to this story. These income tax deductions are called “Depreciation Expenses” for a reason. Often the asset you purchased is in fact losing value. While you may be receiving tax rebate checks in the mail, the market value of the property could be dropping each year, not unlike a used car.   Yes, the value of the land could appreciate to pick up the slack; but it doesn’t always…

It is not uncommon to find out later on that a large real estate purchase was not ideal, or was even outright inappropriate.

Now, there is a bit of a loophole in the way the tax authority looks at old wooden structures, namely ones that are located outside of Japan. According to Japanese law, old wooden structures can be depreciated very quickly; as they should, because very old wooden Japanese buildings are often on the brink of collapse. However, an old wooden structure in a different part of the world could be in a position to stand another 50 years or more. This would provide an opportunity to make enormous annual depreciation deductions while the structure is not actually losing value…

One downside is that if you were to then sell the property, the government would recapture a large portion of the taxes. For example, if you depreciate the building’s value down to zero, and then sell for a number much larger than zero, the entire sale price would be a taxable gain. The Japanese government could also quite easily close this loophole, and remove the preferential tax treatment of old wooden structures with regard to overseas property. It would make logical sense, as this loophole provides no clear benefit to the Japanese economy (tax base is reduced, and private investment capital is sent overseas).

When making investment decisions to the tune of hundreds of thousands or millions of dollars, it is first imperative to undergo an objective analysis of the pure investment value of the property; that it could hold its own as an appropriate and resilient investment decision.

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An investor should be able to answer questions such as:

-Is this property actually a sound investment at this price?

-What is the real investment value of a property?

-What are all the ongoing out-of-pocket costs and taxes involved in owning the property?

We’ll give you a hint: the “comparison approach” to determining price, or whatever someone else recently paid for a similar-enough property in a similar location, is often quite out of touch from the property’s investment value.

A huge risk factor for the investor often stems from the fact that the only professional advice they are receiving to help answer these questions is coming from a real estate broker; whose sole financial incentive is to sell the property regardless of circumstances. It is not our intention discredit the real estate broker field, they provide a valuable service in sourcing and facilitating the transaction; but an investor in real estate would do best to seek an objective professional opinion in assessing the appropriateness of such a large investment.

[sources]

Japan National Tax Agency – Depreciation of Fixed Assets

Journal of Property Investment and Finance – Real Estate Appraisal: a review of valuation methods

G Jason Goddard & Bill Marcum – Springer Texts in Business and Economics – Real Estate Investment: a value based approach

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How To Reduce Tax With Japanese Real Estate Investment
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How To Reduce Tax With Japanese Real Estate Investment
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Reduce tax liability with depreciation of Japanese real estate investments.
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