Owning real estate offers a wide array of benefits, but it's hard to beat the tax advantages of real estate investing. Real estate is a great way to create residual income and diversify your investment portfolio, but many people just aren't aware of the amazing tax benefits that come with it.
Today, we’ll take a look at the top five tax advantages of real estate investing to see how you too, can benefit from these tax savings.
1. Deductions
One of the most basic tax advantages to investing in real estate is the ability to deduct expenses relating to an investment property such as a rental. These are things such as:
Property tax
Property insurance
Mortgage interest
Property management fees
Repairs, capital improvements, or ongoing maintenance
Advertising expenses (The cost to list a rental or market a property for sale)
Many real estate investors choose to own and invest in real estate through an entity, such as a limited liability company (LLC) or limited partnership (LP). In so doing, this opens up a number of additional tax deductions relating to the operation of the investment, such as:
Advertising or marketing expenses such as mailers to find off-market leads, business cards, or a sign for your office
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 niche.
Food
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.
Keep good records of your expenses throughout the year so you can take advantage of the tax savings available to you through real estate deductions.
2. Depreciation
If you own a property that is being used for business or income-producing purposes, (rental property, AirBnB, flip, apartment complex, mobile home park, office building, self-storage, etc.) 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. (The caveat to this is apartments. They are still able to be depreciated over 27.5 years on a standard schedule.) In essence, it's accounting for a decrease in value from average use and 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 years. This can help provide even higher depreciation deductions on your 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%. But, there are methods to avoid depreciation recapture, like a 1031 exchange, among other things.
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 without having to continuously work for it. But passive income is often confused with passive activity.
According to 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 earns 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 go to sell a property for more than you originally purchased it for, the profit will be taxed as a short-term or long-term capital gain, which is typically a lower tax rate than ordinary income tax.
Short-term capital gains, which are properties held one year or less, (Flips) 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, (Rentals) are taxed more favorably, ranging from 0% to 20% depending on your tax bracket.
You can also utilize certain tax-deferred or tax-free methods of investing in real estate to avoid paying capital gains. Allowing for a totally tax free investment.
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 swap an investment property for a like-kind property, thereby avoiding capital gains or depreciation recapture on the sale of the property. However, there are a lot of regulations guarding this method of exchange, such as:
You have 45 days to identify your new investment property. You can only have three options.
You have 180 days to close on said, new investment property
New property must be of equal or greater value than the property sold
Among many other regulations. You always want to be sure that you are fully knowledgeable in any tax strategy you choose to pursue, so you’re able to take full advantage.
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 actually 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 which 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.
Cost Segregation
A Cost Segregation Analysis is a tool used to maximize the tax benefits of owning a commercial property such as an apartment.
Typically the building and its structural components can be depreciated over a 27.5 year period, but everything inside the building – furnishings, fixtures, flooring, appliances, outlets, wiring, roofing, etc. – can be depreciated much more quickly, over 5 to 7 years, maybe even sooner. Because most investors hold commercial properties for 10 years or less, this is a significant tax advantage, making it possible to extract as much as 30 percent of a building’s value during the accelerated depreciation period. These savings are real. Money the owner isn’t paying in taxes can be used for further investments. Equally important, the projected tax savings can make the numbers work on a project that does not otherwise seem financially viable, leading lenders to approve a purchase loan they might otherwise reject.
Bonus Depreciation
Bonus depreciation is a tax incentive that allows a business to immediately deduct a large percentage of eligible assets, rather than write them off over the standard 27.5 year period. Bonus depreciation is also known as the additional first year depreciation deduction.
When you purchase an apartment complex, the cost, for tax accounting purposes, has traditionally been spread out over the useful life of that asset. This process is known as depreciation and can sometimes work in favor of the investor. However, if depreciation is not applied, or if you are only going to hold the property for a 10 year period and you have the standard depreciation schedule over 27.5 years, that’s 17.5 years worth of depreciation that you won’t ever be able to capitalize on.
Instead, with bonus depreciation, you can take 100% of the depreciable amount in year one. Any excess of depreciation unused in the first year can roll over into following years that you hold the asset for up to 20 years.
The Tax Cuts and Jobs Act, passed in 2017, made major changes to the rules on bonus depreciation. Most significantly, it doubled the bonus depreciation deduction for qualified property, as defined by the IRS, from 50% to 100%. The 2017 law also extended the bonus to cover used property under certain conditions. Formerly it applied only to property bought new.
The new bonus depreciation rules apply to property acquired and placed in service after September 27, 2017, and before January 1, 2023, at which time the provision expires unless Congress renews it. Property acquired before September 27, 2017, remains subject to the prior rules. Bonus depreciation is calculated by multiplying the bonus depreciation rate (currently 100%) by the cost basis of the acquired asset. For a business that claims bonus depreciation on an item that costs $100,000, for example, the resulting deduction would be worth $21,000, assuming the company's tax rate is 21%.
Bonus depreciation must be taken in the first year that the depreciable item is placed in service or that the property was purchased. However, businesses can elect not to use bonus depreciation and instead depreciate the property over a longer period if they find that advantageous. I only see that being advantageous if you wanted to hold onto the property for the life of the 27.5 year schedule. If you wanted to sell in year 5 or 10 then it typically makes sense to capitalize on that depreciation.
Real estate tax advantages in action
To really show you how these benefits can grow exponentially, 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 purchase 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.
The tax savings don'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 any other investments. Not to mention, there are benefits of real estate that extend beyond this list, such as appreciation, equity build-up, the ability to leverage your investment, and the ability to force appreciation. Everyone has to pay taxes, but how much tax you pay can be drastically reduced by planning ahead & utilizing certain tax laws available through real estate investing.