Real estate investors are privy to several tax advantages that can help reduce their taxable income, helping them keep more of their money at the end of the year. The U.S. government provides programs like this to encourage people to invest in their communities and abroad. Still, the key is understanding which ones apply to you and how to take advantage of them is worth the time and effort to learn.
While real estate investing can provide significant tax breaks, the key to success is learning to identify these opportunities and understand when and how to use them. These options can be very beneficial in building long-term wealth through the mitigation or avoidance of certain tax obligations.
Here are some of the most significant tax advantages for real estate investors:
Tax advantages in investing in real estate
The IRS allows real estate investors to deduct a certain percentage of their property’s value yearly for depreciation purposes. This means you can write off the cost of your property as an expense. For example, suppose you purchase an apartment building for $1 million, you can write off roughly $35,000 in income utilizing straight line depreciation. This write off amount is found by taking the value of the property and dividing it by 27.5. (The IRS says the useful life of a residential rental property is 27.5 years. Commercial property, excluding multifamily, is depreciated at 39 years.)
The costs to maintain a property add up quickly over time, known as operating expenses. The IRS will allow you to deduct some of these expenses each year in addition to your depreciation schedule. The depreciation deduction, a tax write-off for investors, allows an investor to recover the cost of property through yearly tax deductions.
It’s based on three things:
- the basis of the property (how much is the property worth?)
- the recovery period for the property
- the depreciation method used
Generally, investors use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS). Depreciation is categorized as a net loss on investment property, even if it produces positive cash flow.
The two methods most commonly used are:
- Straight-line Method spreads the cost evenly over its useful life (determined by IRS). This can be calculated using Form 4562, which we’ll discuss later in this article;
- The accelerated Method allows businesses to reduce their tax burden faster by claiming more significant deductions in early years than those declared under the straight-line Method.
- Expenses and write-offs
One thing many people need to realize about rental properties is that they tend to come with more than just mortgage payments. There are also repairs, utilities, and maintenance fees that can be costly. With traditional bank loans on commercial real estate projects like this one, strict limits can be placed on how much money can be spent on any given repair project or utility bill. This is because banks want their own assets protected before anything else happens under any circumstances. However, when using private money lenders, those rules don’t apply anymore so long as the lenders feel comfortable lending without asking questions first.
As an investor, you can deduct the following expenses related to your property:
- Ordinary repair and maintenance
- Home office deduction (for owners who use part of their home exclusively and regularly for business)
If your rental property is a single-family home, condo, or co-op apartment, it’s considered residential real estate. The IRS lets investors write off certain expenses by using what’s called accelerated depreciation. 2022 is the last year investors will be able to take advantage of accelerated depreciation.
3) 1031 Exchange
The Internal Revenue Code (Section 1031) allows taxpayers to swap one real estate investment asset for another without incurring a tax liability. For example, suppose you purchase a piece of real estate to sell at a profit soon. In that case, you are liable for taxes on any gains made from the property. However, if you were to swap this same property for another piece of real estate and hold both properties for productive purposes in business or trade, there would be no tax liability at the exchange time.
Because this transaction is exempt from direct taxes, you can defer paying taxes until the sale of your final asset. To qualify for the 1031 Exchange, the properties involved must be held for business purposes and exchanged for tangible assets.
4) Selling your primary residence.
It’s possible to save on taxes by selling your primary residence. You can then use the proceeds from that sale to buy another home, which may allow you to deduct your losses from capital gains tax in the new purchase.
The amount of money saved depends on your tax bracket and whether or not you have other capital gains during the same year. This is an excellent way for investors with high incomes (which puts them in a higher tax bracket) to save some money on their taxes if they’re planning to buy another house anyway. However, this option isn’t available yearly. If you lived in your primary residence two out of the last 5 years, you won’t pay capital gains on the sale of your house up to $250k for single individuals and $500k for married couples.
5) Refinancing investment properties
By refinancing your investment properties, you can improve your cash flow. You can do a “term and rate refi” to reduce the amount of money that you are paying each month on your mortgage, which will save you money. You can also do a “cash out refi” and take out additional cash from the equity in the property without being taxed on this equity until you sell it.
6) No Income Tax
The IRS does not consider real estate investment to be a business; therefore, there is no income tax on the gains. The only exception to this rule is if you own your real estate in a holding company and pay yourself a salary. If you materially participate in managing the property, you may be able to deduct up to $25,000 of losses and carry those losses forward for future tax periods.
Real estate investors get several tax advantages.
First, there’s depreciation. This is the simplest tax advantage available to real estate investors and one of the best reasons to invest in rental properties. Depreciation allows you to deduct part of your property’s value from your income each year based on its useful life. The next major tax advantage comes from expenses and write-offs associated with owning rental properties: mortgage interest payments; insurance premiums; property taxes; maintenance costs for repairs or equipment upgrades; management fees paid directly by tenants to their landlord-employer—all these may be deducted from gross income when calculating your annual taxable income at the end of each year.
The benefits of owning a home for yourself or your family are priceless, but when you’re looking to invest in real estate, it’s important to take advantage of all these tax benefits as well. It can be tough to keep track of everything that goes into buying a property—especially if you have multiple properties. Tax strategies, including the use of depreciation, can help real estate investors maximize the value of their properties.
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 personal or business.
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