For both seasoned and new real estate investors, diversifying your investment portfolio is always a smart move. In addition, purchasing rental properties can generate a valuable, recurring cash flow from a largely passive income. But did you also know that it can also improve your financial outlook come tax time?
Continue reading to learn about the numerous tax advantages of real estate investing and how to maximize your annual return savings.
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1: Make Use of Real Estate Tax Write-Offs
One of the greatest financial advantages of this source of income is the ability to deduct taxes associated with real estate investments. You can deduct expenses like these that are directly related to the property’s management, operation, and upkeep.
Cost of building upkeep and repair, including property taxes, insurance, mortgage interest, and management fees. Did you know that you can also deduct a lot of the costs associated with running your real estate investment business?
The following are examples of qualified business expenses:
- Advertising Equipment for businesses (such as computers, stationery, and business cards)
- Travel, legal and accounting fees, and other expenses
All of these deductions reduce your taxable income, which may help you save money on taxes.
So, for example, let’s say you make $25,000 a year renting, and you spend $8,000 on qualified expenses related to it. This indicates that your real estate company’s taxable income is $17,000.
Pro tip: In the event that you are subject to an audit by the Internal Revenue Service (IRS), new real estate investors need to be able to demonstrate the expenses that you claimed by keeping receipts and detailed records that are accurate.
2: Costs Depreciate Over Time
Depreciation is the gradual loss of an asset’s value, usually because of wear and tear. It can be deducted from your taxable income as a real estate investor who owns rental properties that generate income. As a result, both your taxable income and potential tax liability will decrease.
The IRS currently sets the expected life of a property at 27.5 years for residential properties and 39 years for commercial properties, but you can deduct depreciation for the entire expected life.
For instance, you might buy a house with the intention of renting it out. The building itself is worth $300,000, not including the land it sits on. You can deduct $10,909 in depreciation each year by dividing that value by the 27.5-year expected life of the house.
3: Use a Pass-Through Deduction
On your personal taxes, you can deduct up to 20% of your qualified business income (QBI) using a pass-through deduction. Real estate tax law considers the money you collect in rent as QBI when you own rental property as a sole proprietor, through a partnership, or through an LLC or S Corp (known as pass-through entities).
For example, if you own an apartment complex through an LLC, you might be able to earn $30,000 annually from rent. On your personal tax return, you can deduct up to $6,000 by using a pass-through deduction. Naturally, certain rules and regulations must be adhered to; therefore, please consult a tax professional with any landlording questions.
4: Profit from Capital Gains
When you sell an asset, like a property, for a profit, you may be subject to capital gains tax. There are two kinds to keep an eye out for: both in the short and long run. Your tax situation is affected differently by each of them.
Short-Term Capital Gains
A short-term capital gain is when you make money from selling an asset within a year of owning it. Be aware that selling can have a negative impact on your taxes, even if you have no choice but to do so. This is because the gain is considered regular income.
Therefore, for tax purposes, your income effectively doubles if you earn $100,000 from your day job and sell an investment property for $100,000. If you file as a single person, this additional income places you in the next tax bracket (as of 2020), which could result in a higher tax bill than you anticipated.
Long-Term Capital Gains
On the other hand, if you profit from the sale of an asset that you have held for at least one year, you will experience a long-term capital gain. You will be able to keep more money in your pocket if you can postpone selling until the anniversary of your purchase. This is due to the fact that the tax rate on long-term capital gains is significantly lower than that of your standard income.
Additionally, you may not be required to pay the tax at all if your income is low enough. Let’s say you and your spouse file a joint tax return and earn $75,000 annually. Because the tax rate for your level of income is 0%, long-term capital gains are exempt from taxation. This means that when you sell a property, you can keep every penny of the profit.
5: Incentive Programs to Defer Taxes
Sometimes, the government creates a unique tax code to encourage investors. Let’s take a look at two significant real estate tax benefits: the 1031 exchange and opportunity zones.
1031 Exchange
The government wants to reward people who reinvest their real estate profits in new deals, which is why 1031 exchanges exist. The program allows you to swap properties for tax purposes so long as the new property you buy is equal to or greater than the property you sell. This indicates that you can postpone paying the capital gains tax until after the first property is sold.
1031 exchanges can be used anytime. However, if you wish to withdraw your profits, you will be required to pay any owed taxes. Depending on the timing of your purchase and sale transactions, the program comes in a few different forms. It’s a good idea to talk to an experienced financial advisor because the program can be hard to use and navigate.
Opportunity Zones
Low-income or disadvantaged tracts of land are designated opportunity zones by the U.S. Department of Treasury. By providing tax breaks, the 2017 Tax Cuts and Jobs Act encourages investors to invest in the growth and economic stimulation of these communities.
You can take advantage of the following tax advantages if you follow the program’s rules:
- Wait until 2026 (or until you sell your stake in the fund) to pay capital gains.
- If you keep the fund for five years, you can double your capital gains by 10%; 15% over seven years.
- If you remain invested in the fund for more than ten years, you can completely avoid paying capital gains.
6: Work For Yourself Without Having To Pay The FICA Tax
When you work for yourself, you usually have to pay both the employer and employee portion of FICA tax, which covers Social Security and Medicare. However, the money you receive is not considered earned income if you own rental property. This indicates that you are eligible for one of the real estate tax breaks that are rarely discussed: avoiding the payroll tax, which is also known as the FICA tax.
How It Works:
Let’s pretend that you own a $50,000-a-year freelance writing business. You are responsible for paying the payroll tax because that money is considered earned income. You would have to pay over $7,650 in taxes at a rate of 15.3%. However, if you owned a rental property instead, you would be able to keep that money in your bank account.
More Resources For New Real Estate Investors
Taking advantage of tax breaks is just one of the many benefits of real estate investing. If you’re a new investor, there’s never been a better time to start to make money on your investments.
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