Owning real estate offers a number of benefits, but it’s hard to beat the tax advantages of real estate investing. Real estate can be a great way to create residual income or diversify your investment portfolio, but many people aren’t aware of the great tax benefits that come with it.
Take a look at the top five tax advantages of real estate investing to see how you (and your wallet) can benefit from these tax savings.
One of the most basic tax advantages to investing in real estate is the ability to deduct certain expenses relating to an investment property such as a rental, which may include:
- Property taxes.
- Insurance premiums.
- Interest on mortgages for properties involved with rentals or sales (a mortgage lender will pay interest until they are paid back).
- Fees related specifically to renting out your place and maintaining it properly while doing so – like paying someone professional fees when you need them say if there’s plumbing trouble that needs fixing ASAP. You can also write off advertising costs needed for rents/sales listings too!
One of the reasons many real estate investors choose to own and invest in property through a limited liability company or partnership is that it opens up additional tax deductions relating to the operation of an investment business including advertising, legal fees, office equipment like computers and printers. A home office can also be deducted as well! Investing with these entities allows you to take advantage of all those great benefits while still enjoying your time off work for investing.
The importance of figuring out the right deductions is paramount to maximizing your return. For example, you can only deduct 50% of a meal expense or $5 per square foot from home office space but there are many other expenses that provide valuable tax benefits such as capital improvements which must be depreciated over time and business related travel costs for when you do not have an established place of work.
If you keep good track of your expenses throughout the year, you can take advantage of the tax savings available through real estate deductions.
A property owner can depreciate the cost of a rental or commercial building they hold for more than one year. A depreciation is when an individual records their income over time for tax purposes to allow them to take advantage of any losses from wear and tear, damage, disaster recovery costs etc., that are incurred during its lifetime. For residential buildings this period would be 27 years while it’s 39 years in case of commercial properties
For example, if you purchased a SFR (single-family residence) for $150,000, you could deduct an annual depreciation of $5,545 each year ($150,000/27.5 years). You can also depreciate certain capital expenses like replacing a roof or installing a new HVAC system over the course of years. This helps provide deductions you otherwise wouldn’t have on your annual taxes, making it worth considering this for anyone who wishes to take advantage of opportunities to save money in their tax bracket.
Depreciation can only be used on investment properties, making it a huge tax advantage available only to real estate investors.
When a property is sold, the depreciation amount that was previously deducted as an expense can be recaptured and taxed at an ordinary income rate of up to 25%. This means if you’ve accumulated significant losses in your business over time, or other capital assets like cars and boats which are now being used for personal use instead of business purposes; then it may make sense to consider selling before they fall subject to this tax.
3. Passive income and pass-through deduction
The passive income that you earn is often confused with the act of being lazy. In reality, it means your hard work has already paid off and now you’re free to enjoy life without having to take on any more responsibilities or time-consuming tasks!
The Internal Revenue Service (IRS) defines passive income as any money earned from rental activity or business in which they don’t materially participate. Passive income is specifically excluded residual income earned by a person on dividends and interest through their mortgage note, but it’s most commonly seen among real estate investors who earn rental incomes.
Before 2018, the only way to offset passive income was with passive losses. But when the Tax Cuts and Jobs Act was passed, it allowed businesses who earned qualified business income (QBI) which includes rental income, to pass up to 20% of taxable income using a pass-through deduction. It’s important to note that you can only take advantage of the pass-through deduction if your business is profitable and not all income types qualify for this deduction, which is currently available until 2025.
4. Capital gains taxes instead of income taxes
When you sell a property for more than the purchase price, your profit will be taxed as either short-term or long term capital gains. This is typically lower than income tax and can provide some relief on taxes due to its designation.
You can utilize certain tax-deferred or tax-free methods of investing in real estate to avoid paying capital gains. Short-term capitals gain, which are properties held one year or less, range from 10% to 37%. Long term capital gain is taxed more favorably and ranges from 0% – 20%, depending on your income bracketThese methods are outlined below.
5. Invest tax-deferred or tax-free
A 1031 exchange is a legal transaction that allows real estate investors to swap an investment property for like-kind properties in order to avoid capital gains or depreciation recapture on the sale of said property. This operation is named after Section 1031 of the IRS tax code.
Tax-free or tax-deferred retirement accounts
Investing in real estate through tax-free or tax deferred accounts can be a great way to avoid taxes and still get the benefits of investing. These special savings account like HSAs, IRAs, or Solo 401ks allow you to invest your money into alternative assets including stocks, bonds, mutual funds etc with as little risk (or more) than traditional investment methods! The annual contribution limits vary depending on which type of account you open but it’s worth opening one if this is something that interests you because there are different restrictions for each kind – so do some research before jumping right in.
Opportunity zones are one of the most exciting new incentives in recent years, and investors have been rushing to take advantage. These areas were chosen because they represent some of the poorest counties across America with many rural towns struggling for growth. The incentives rolled out as a part of Trump’s Tax Cuts and Jobs Act allows wealthy individuals who invest their capital gains into an opportunity zone fund can defer paying taxes on them or pay no capital gains at all depending on how long it is held there.
Opportunity zones are still relatively new, this means there’s still a lot going on with requirements, rules, and changes happening constantly so make sure you’re updated with the latest regulations.
Real estate tax advantages in action
To really show you how these benefits can add up, let’s look at an example of a basic real estate transaction that utilizes a few of the real estate tax advantages available today.
You buy a rental property for $150,000, putting 20% (or $30,000) down. The annual rental income is $16,000 with $13,000 in expenses, giving you a net income of $3,000. With the depreciation deduction, you are able to deduct an additional $5,454, producing a net loss of nearly $2,500. Essentially you get to earn $3,000 a year in passive income, yet pay taxes on none of it. If you have additional passive income that is not a net loss, you can use this passive loss to offset that income.
But that tax savings doesn’t end there. Let’s assume this is not your only real estate investment, and that you own this property and other real estate investments in an LLC, earning around $20,000 a year in qualified business income. You could utilize the pass-through deduction, reducing your net income by an additional 20% (or $4,000) to $16,000.
You decide to sell the property 10 years later for $200,000 using a 1031 exchange. This helps you avoid having to recapture $54,540 in depreciation and you are able to roll $50,000 of capital gains into a new investment property that produces a net cash flow of $9,000 a year instead of $3,000 a year.
Over the 10 years of ownership, you paid little to no taxes, collecting roughly $30,000 in passive income before converting it into a new investment that yields triple your original return.
While this is a basic illustration of how real estate tax advantages could work, it’s not that far-fetched. Real estate is one of the most tax-advantaged investments compared to other investments. Not to mention, there are benefits of real estate that extend beyond this list, such as appreciation, equity build-up, or the ability to leverage your investment. Everyone has to pay taxes, but how much tax you pay can be reduced by utilizing certain tax laws available in real estate.
The “Unfair Advantages” of Real Estate Just Got a Whole Lot Better
Investing in real estate has always been one of the most effective paths to financial independence. That’s because it offers incredible returns and even more incredible tax breaks.
These benefits weren’t enough for Uncle Sam, though, as a new tax loophole now allows those prudent investors who act today to lock in decades of tax-free returns. In Voyager Pacific Capital we’ve put together a newsletter that details how you can benefit from this once-in-a-generation investment opportunity. Simply click here to get your free copy.