Deductions |Capital Gains |Depreciation | 1031 Exchange | Tax-Deferred Retirement Accounts | Self-Employment/FICA Tax |Opportunity Zones
What are the best investment property tax benefits?
Real estate continues to be one of the most popular investment strategies for protecting and growing one’s wealth. Combined with the enticement of generating cash flow, investing in real estate also opens a treasure chest of tax advantages that renting does not. Uncle Sam can become an investor’s best friend as a slew of investment property tax benefits are available. The trick, however, is understanding what’s available and how to capitalize on it.
Navigating The Top Investment Property Tax Benefits
As one of the preferred investing options, real estate offers big tax incentives on everything from rental properties, apartments, vacant land, industrial and commercial buildings, and shopping centers. For investors, ownership of real estate can produce substantial tax savings, including tax sheltering.
While real estate does offer a handful of tax benefits to investors, these tax breaks can be overwhelming for many. Here we’ll break down the top real estate investing tax benefits, including some of the top write-offs and deductions for real estate investors:
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Deductions
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Passive Income & Pass-Through Deductions
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Capital Gains
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Depreciation
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1031 Exchange
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Tax-Deferred Retirement Accounts
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Self-Employment/FICA Tax
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Opportunity Zones
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Deductions
Many property owners wonder, “what can you write off when you buy a house?” You will be happy to know one of the biggest investment property tax benefits available for owners is in the form of deductions. These tax write-offs, generally geared towards rental properties, will include costs associated with mortgage interest, property tax, operating expenses, depreciation, and repairs. Let’s explain:
As the property manager, you can deduct the ordinary and necessary expenses for managing, conserving, and maintaining the property. These business finances will generally include mortgage interest, property taxes, advertising, maintenance, utilities and insurance. Investors can write off repairs because repairs keep a property in good condition and do not add value to the property. Examples include fixing leaks, painting, and replacing broken parts of the rental property. According to I’m Anthony Martin, the CEO and founder of Choice Mutual, “since investing in real estate helps you save money on your taxes through various deductions, it’s a form of tax shelter. By lowering their taxable income through viable tax deductions- investors can save money when they’re left with lower tax liabilities. Or, in some cases, no tax liability”.
Investors can also deduct their mortgage interest on their primary — and sometimes secondary — residence. This deduction applies to home purchases or newly refinanced mortgages, home equity lines of credit, and home equity loans. Another deduction for investors who purchased a home in
Tip: It’s important that investors itemize deductions carefully. For investors starting a business, deductions can also come in the form of non-real estate activities such as using your home office. In many cases, investors will deduct a portion of their home working expenses such as Internet and phone bill.
It’s also important to understand what you can’t deduct from your investment property taxes. This should go without saying, but know that you can’t receive any deductions on a property you don’t own. You also can’t deduct any property taxes you haven’t paid yet. Assessments make up an important category of expenses that you can’t deduct. Whether it be for your homeowners association, or for neighborhood streets, sidewalks, and sewer systems, assessments cannot be deducted. However, you can deduct the cost of maintenance or repair of these things, since they don’t increase property value. You also cannot deduct the portion of your taxes that pays for services, such as water or trash, nor can you deduct any transfer taxes on the sale of a property.
Passive Income & Pass-Through Deductions
Passive income, in regards to real estate, is any money that is earned from business activity that investors do not physically participate in. The most common form of passive income is rental income earned through an investment property. Before 2018, rental property investors could only offset passive income through passive losses. However, passive income investors gained some benefits thanks to the Tax Cuts and Jobs Act of 2018. It enables businesses that earn qualified business income (QBI), which includes rental income, to pass up to 20 percent of their taxable income. They can do this by using a pass-through deduction. This reduces the effective income tax rate by 20 percent, which is quite the reduction. This benefit is available until 2025; it remains yet to be seen whether this Act will be renewed.Note that you can only take advantage of this pass-through deduction if your business was profitable in your tax reporting year. Not all income types qualify for this pass-through deduction. If you are interested in deducting any other type of income besides your rental income, it would be wise to double-check the Internal Revenue Services (IRS) rules on passive income and pass-through deductions.
Capital Gains
Capital gains are the profits that homeowners make when they sell their real estate property, which includes a rental, residential, commercial or industrial property. They are generally taxed in one of two ways: 1. short-term capital gains; 2. Long-term capital gains.
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Short-Term: This applies for gains on investment properties that were held for one year or less. While there is no special tax treatment for short-term capital gains, investors will need to pay taxes at their regular IRS-defined tax bracket.
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Long-Term: These capital gains are made on properties that were held for over one year, which are generally linked with rental properties. Capital long-term gains are much more favorable for investors as it’s a lower tax rate than short-term gains.
Tip: As an investor, long-term capital gains is the way to go. You’ll be taxed far less and you can utilize previous deductions to lower the taxable amount.
Steve Scott, CTO at Spreadsheet Planet says “in my opinion, if you invest in income properties for the long term, the profits you earn on the sale will be taxed as long-term capital gains, which are taxed at 0%, 15%, or 20%, depending on your income band. If you invest for the short term (e.g., flipping or wholesaling), you will not benefit from any unique tax treatment, as all of your gains will be taxed at the higher short-term capital gains rate”.
Also, investors need to know about the capital gains exclusion, which is probably the biggest of all the investment property tax benefits. This can be used more than once to allow homeowners to be exempt from paying taxes on profits up to $500,000 from selling their homes. In a worst-case scenario, if capital losses exceed capital gains, investors will be allowed to offset upwards of $3,000 of other income. It’s a win-win for investors.
Depreciation
Another huge tax break that applies to rental properties is depreciation. In essence, this entails recovering the cost of income-producing property through yearly tax deductions. According to the IRS, the depreciation deduction is defined as an allowance for exhaustion or wear and tear. Three factors determine how much depreciation an investor can deduct each year. They include:
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Their basis in the property (how much is the property worth?)
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The recovery period for the property
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The depreciation method used.
Investors typically use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS). The IRS allows investors to deduct depreciation on a piece of residential property for 27.5 years and 39 years for commercial real estate. Depreciation is categorized as a net loss on an investment property, even if the property produces positive cash flow.
Tip: Because investors already deduct the cost of their rental property, the depreciation deduction offers investors an innovative way to save money every year.
1031 Exchange
Named for Section 1031 of the Internal Revenue Code, a 1030 Exchange is a swap of one real estate investment asset for another. While most investment swaps are taxable as sales, a 1031 Exchange will have no tax — or limited tax — at the time of exchange. For investors, this means you can roll over gains from one piece of real estate investment to another, avoiding taxes until you actually sell it a year later.
To complete a 1031 exchange, investment properties must meet the following criteria:
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The value of the replacement property must be equal to — or greater — than that of the resigned property.
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Properties in the transaction must be exchanged for some type of asset, such as a real estate investment trust (REIT).
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The exchanged property must be held for “productive purposes in business or trade.”
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Tax-Deferred Retirement Accounts
Some health savings accounts (HSA) and individual retirement accounts (IRA) offer investors the opportunity to buy real estate tax-deferred (meaning they can invest in real estate now and pay taxes on it later). However, certain accounts have annual contribution limits and restrictions on the types of investments that can be made, so be sure to do your research in advance.
Self-Employment/FICA Tax
As a real estate investor, this tax benefit will save you on the income you receive from rental properties. FICA, which stands for Federal Insurance Contributions Act, is a 15.3 percent tax split 50/50 between an employer and the employee. As a business owner self-employed, you are responsible for the full 15.3 percent tax. However, it can be offset depending on how you legally structure your real estate business.
Opportunity Zones
Opportunity zone funds were introduced as a tax incentive in 2018 as part of the Tax Cuts and Job Act to encourage growth in over 8700 opportunity zones across the US. To be clear, opportunity zones are some of the country’s most rural and distressed areas. Investors can put the capital gains they earned from selling an investment property into an opportunity zone fund, allowing them to defer or pay no capital gains tax on their original investment. As a new program, the rules and requirements are often adjusted, so check for any new changes.
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Stay Organized
When tax time rolls around, you will maximize your real estate investment tax deductions if you diligently keep good records. To organize your records for investment property tax benefits, you should:
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Keep all your receipts
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Organize what you spent on your property
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Track all potentially deductible business expenses
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Prepare and maintain financial statements
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Sort the types of investments you made on your property
Keeping yourself organized will result in easier tax return calculation, and your overall bottom line will benefit. Not only will your accountant thank you, but you can avoid any challenges from the IRS by keeping up-to-date information on your finances.
Investment Property Tax Benefits Example
Let’s go through a concrete example to help illustrate just how investment property tax benefits can add up.
Let us say that you buy an income property for $400,000. You put down 20 percent, which is $80,000. The property generates a net income of $10,000 (annual rental income of $30,000 with $20,000 in expenses, including your mortgage payments.) The depreciation deduction allows you to deduct an additional $14,544 (3.646 percent), so you have a net loss of $4,5444. This means that you earned a passive income of $10,000 in the first year, yet you didn’t have to pay taxes on any of it because you are reporting a net loss.
This is just one example of tax savings. You can also utilize a pass-through deduction to reduce your personal net income by another 20 percent. Further, you can use a 1031 exchange to sell your property for a profit. You can roll over your profit to purchase a new investment property that produces a better income while avoiding recapturing your depreciation.
In summary, the tax advantages could put you in a favorable position of earning passive income on which you pay little to no taxes. In addition, you can leverage your profits to level up your investments without having to pay taxes on capital gains.
Purchasing An Investment Property For Tax Purposes
There is no denying that real estate can hold a number of tax benefits. One idea that circulates around every now and then, is whether investors should purchase property to tap into these benefits. After all, rental property owners property tax deductions and other benefits can be significant. However, if your sole aim is to achieve deductions or offset other investments, you most likely should not purchase an investment property for tax purposes. There are numerous components to real estate investing, buying a property without a full understanding the market or financing will almost certainly end poorly.
If you are interested in making an investment and want to select a strategy with certain tax benefits, real estate is one option to consider. Again, there are numerous factors of a real estate transaction. Read up on the basics of real estate investing before you decide to purchase a property, and consider how the opportunity aligns with your financial goals.
Summary
Some of the greatest benefits of investing in real estate are the available tax breaks. Still, the barrier for many is being unaware of these opportunities and how to take advantage of them. Understanding which investment property tax benefits are at your disposal is one of the best ways that real estate investors can achieve long-term wealth. Take advantage of these tax breaks and ensure you stay on the path to financial freedom while protecting yourself from avoidable fees.
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