The Top 5 Tax Benefits of Real Estate Investing
There are many benefits to investing in real estate. Passive income, Appreciation, Diversification… those are usually the terms you hear when discussing the advantages of this particular investment vehicle. However, there is one advantage that is commonly underrated: Tax Benefits.
We’ve outlined the top five tax advantages of real estate investing to see how you (and your wallet) can benefit from these tax savings.
1. Deductions
When you invest in real estate, you become a business. As a business, you have the ability to deduct certain expenses relating to an investment property. This can include:
Property tax.
Property insurance.
Mortgage interest.
Property management fees.
Property repairs, capital improvements, or ongoing maintenance.
Advertising expenses (i.e. listing and marketing costs to promote a rental)
Additionally, many real estate investors choose to own and invest in real estate with an entity, such as a limited liability company (LLC) or limited partnership (LP). This yields a number of additional tax deductions relating to the operation of the investment business including:
Advertising or marketing expenses such as mailers, business cards, or office signage.
Legal and professional fees such as an accountant, attorney, or bookkeeper.
Business equipment such as a laptop, printer, office desk, or phone.
Office space, including a home office.
Communication such as internet, a PO box, or phone line used for business purposes.
Travel expenses including your vehicle mileage and parking fees.
Education and memberships such as the annual fee for a trade association or cost for a seminar, book, or course on a topic relating to your industry.
Meals with a partner or company involving a business transaction
Most of the property-related expenses can be deducted at face value, although some, like capital improvements, are depreciated over a period of time. Many business deductions are a portion of the expense. For example, you can only deduct 50% of your meal expense, or $5 per square foot of your home office, with a maximum of 300 square feet.
Maintain a detailed record of your annual expenses to reap the most tax savings available through real estate deductions.
2. Depreciation
If you own a property that is being used for business or income-producing purposes (like a rental property), for a year or more, you can depreciate the cost of the property over time.
Depreciation is the method of deducting a property's loss in value over its expected life, which for residential property is 27.5 years, and commercial property is 39 years. In essence, it's accounting for a decrease in value from average wear and tear.
For example, if you purchased a single-family rental for $200,000, you could deduct an annual depreciation of $7,272 each year ($200,000/27.5 years). You can also depreciate certain capital expenses like replacing a roof or installing a new HVAC system over a period of time. This can help provide even greater depreciation deductions on your annual taxes.
Depreciation can only be used on investment properties, making it a huge tax advantage available only to real estate investors.
Unfortunately, depreciation doesn't last forever. When the property is sold, the depreciation is recaptured. The depreciated amount is then regained and taxed as ordinary income with a maximum tax rate of 25%. There are methods to avoid depreciation recapture, like a 1031 exchange (more information on this below).
3. Passive income and pass-through deduction
Real estate is frequently praised for its ability to produce passive income, which is cash flow that is earned with minimal effort or action.
Defined by the Internal Revenue Service (IRS), passive income is any money that is earned from rental activity or business activity in which they don't materially participate in, yet it explicitly excludes residual income earned from a passive investment such as dividends or interest from a mortgage note. That means passive income in real estate is most commonly earned from rental income.
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 earn 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.
4. Capital gains taxes instead of income taxes
When you sell a property for more than you originally purchased it for, the profit will be taxed as a short-term or long-term capital gains, which is typically a lower tax rate than ordinary income tax.
Short-term capital gains, which are properties held one year or less, can range from 10% to 37% depending on your income bracket. Long-term capital gains, which are properties held a year and one day or more, are taxed more favorably, ranging from 0% to 20% depending on your tax bracket.
You can utilize certain tax-deferred or tax-free methods of investing in real estate to avoid paying capital gains. These methods are outlined below.
5. Invest tax-deferred or tax-free
1031 exchanges
Named after Section 1031 in the IRS tax code, a 1031 exchange is a legal transaction that allows real estate investors to trade an investment property for a like-kind property, thereby avoiding capital gains or depreciation recapture on the sale of the property.
Tax-free or tax-deferred retirement accounts
There are special savings accounts like a health savings account (HSA), or special individual retirement accounts (IRA) like a Solo 401k, SEP IRA, or Self Directed IRA that act allows you to invest in alternative assets, including real estate, tax-free or tax-deferred. Annual contribution limits vary depending on the type of account you open, and there are different requirements prohibiting who and what you can invest in with each account, however, this can be a great way to avoid taxes but still invest in real estate.
Opportunity zones
Opportunity zones are over 8,700 designated census tracts making up some of the most rural and distressed areas of our country. To stimulate growth in these areas, a new tax incentive was rolled out as a part of the Tax Cuts and Jobs Act. This incentive allows investors to roll qualified capital gains into an opportunity zone fund, thereby deferring capital gains or paying no capital gains depending on how long the investment is held in the fund.
Since this is still a relatively new opportunity, changes and further clarification of the rules and requirements of this program are being made regularly.
Knowing these real estate investment tax strategies is important not only for squeezing out all possible deductions but for making investment decisions as well. A comprehensive understanding of where your deductions are coming from, how they will be applied and the amounts to be expected can all help influence future strategies, whether they are personal or business in nature. There are many benefits and advantages to Real Estate Investing, and tax benefits are just one. If you are ready expand your investment portfolio, contact a lender at Carlyle Capital and we will be happy to discuss any loan scenario you are considering.
