You must be aware of the importance of diversifying your investments for financial security. And you may have also heard about the potential for buying rental properties to generate a reliable source of recurring income with minimal active involvement. But did you know that investing in rental properties can also positively impact your tax situation, potentially brightening your financial outlook during tax season?
Continue the read to discover the numerous tax advantages of investing in real estate and uncover strategies to optimize your annual tax savings.
1. Use Real Estate Tax Write-Offs
One of the notable financial benefits of this revenue source arises from the tax deductions accessible for investing in real estate. You can deduct costs that are closely linked to the functioning, administration, and upkeep of the property, such as:
- Property taxes
- Property insurance
- Mortgage interest
- Property management fees
- Cost to maintain and repair the building
However, were you aware that you can also claim deductions for a significant portion of your expenses related to running your real estate investment business? Eligible business expenses may encompass, though are not confined to:
- Advertising
- Office space
- Business equipment (e.g., computer, stationery, business cards, etc.)
- Legal and accounting fees
- Travel
Each of these deductions reduces your taxable income, potentially resulting in tax savings. For example, if your rental income is $25,000 and the eligible expenses are $8,000, your taxable income from your real estate business would be $17,000.
2. Depreciate Costs Over Time
Depreciation refers to the gradual reduction in the value of an asset, typically due to anticipated wear and tear. As a real estate investor who owns rental properties generating income, you can claim depreciation as an expense on your tax return. This allows you to reduce your taxable income and potentially lower your overall tax liability.
You have the opportunity to claim the depreciation deduction for the entire projected lifespan of a property, as determined by the IRS, which is currently set at 27.5 years for residential properties and 39 years for commercial properties.
As an example, let’s consider a scenario where you acquire a property with the intention to rent it out. The value of the building (excluding the land) is $300,000. If you divide this value by the expected 27.5-year lifespan of the dwelling, you can claim a depreciation deduction of $10,909 per year on your taxes.
After you sell, however, be ready to face the regular income tax rate on the depreciation you have previously claimed. This condition is referred to as depreciation recapture, and you can circumvent it by employing alternative tax tactics such as a 1031 exchange (more details are provided below).
Pro tip: Consult your accountant for advice on how to depreciate substantial enhancements you have made to your investment properties, such as the installation of a new roof.
3. Use A Pass-Through Deduction
A pass-through allowance permits you to deduct a maximum of 20% from your qualified business income (QBI) when filing your individual tax return. If you have rental property ownership as a sole proprietor, a partnership, or via an LLC or S Corp (commonly known as pass-through entities), the rental income you receive is considered QBI under real estate tax regulations.
For example: suppose you have an LLC that possesses an apartment complex and generates $30,000 in annual rental income. By leveraging a pass-through deduction, you could potentially deduct up to $6,000 from your individual tax return. However, it’s essential to adhere to relevant rules and regulations, and it’s advisable to consult with your accountant for professional guidance.
Please note: This benefit, along with other provisions within the Tax Cut and Jobs Act of 2017, is presently scheduled to lapse in 2025.
4. Take Advantage Of Capital Gains
When you sell an asset, such as a property, and realize a profit, you may be subject to a capital gains tax. It’s crucial to understand the two types: short-term and long-term, as they have distinct implications on your tax status.
Short-Term Capital Gains
If you sell an asset and make a profit within a year of acquiring it, it results in a short-term capital gain. While you may not have the option to avoid selling, it’s crucial to be aware of the potential adverse impact on your taxes. This is because the gain is treated as ordinary income, which can potentially increase your overall tax liability.
As an example, if you earn $100,000 from your primary job and realize a $100,000 profit from selling an investment property, your total income effectively doubles for tax purposes. If you file as single, this additional income could push you into the next tax bracket (as per 2020 rates), potentially resulting in a larger-than-expected tax bill. It’s vital to be aware of the impact of capital gains on your overall tax liability and plan accordingly.
Long-Term Capital Gains
Alternatively, if you’re able to hold onto an asset for a year or more before selling it, you’ll likely qualify for long-term capital gains. This means that you’ll be able to keep more of the profits from the sale, as long-term capital gains are taxed at a lower rate compared to regular income. Waiting until the anniversary of your purchase to sell can result in significant tax savings, allowing you to retain more money in your pocket.
Furthermore, if your income falls below a certain threshold, you may be exempt from paying any taxes on long-term capital gains. For example, if you and your spouse have a combined annual income of $75,000 and file a joint tax return, and the tax rate for your income level is 0%, then any long-term capital gains you make from selling a property would be tax-free. This means you get to keep 100% of the profit without having to pay any taxes on it.
5. Defer Taxes With Incentive Programs
Occasionally, the government may create specific tax codes aimed at encouraging investment. Two significant real estate tax benefits worth considering are the 1031 exchange and opportunity zones.
1031 Exchange
The concept of 1031 exchanges stems from the government’s intention to incentivize individuals who reinvest their real estate profits into new opportunities. This program allows you to swap properties for tax purposes as long as the new property you purchase is of equal or greater value than the one you sell. As a result, you can defer paying the capital gains tax on the sale of the first property, potentially saving you money in the short term.
You can utilize 1031 exchanges continuously without any time limitations. However, when you decide to liquidate your gains, you will be required to settle any outstanding tax liabilities. There are various options under the program, depending on the timing of your buying and selling activities. Due to the complexities involved in maximizing the program’s benefits, it is advisable to seek guidance from a qualified financial expert.
Opportunity Zones
Opportunity zones, identified by the US Department of Treasury, are areas characterized by low-income or economic disadvantage. The 2017 Tax Cuts and Jobs Act aims to incentivize investors to contribute to these communities’ development and economic revitalization by offering tax breaks.
You invest your unrealized capital gains with fellow real estate investors into a Qualified Opportunity Fund. The capital from the fund is then earmarked for enhancing the chosen area through targeted improvements and initiatives.
By adhering to the regulations of the program, you can reap the following tax benefits:
- You can postpone the payment of capital gains taxes until 2026 or until you sell your stake in the fund by complying with the program’s rules.
- If you hold the fund for 5 years, you can increase your capital gains by 10%, and by 15% for 7 years, allowing your investment to grow.
- If you hold the fund for more than ten years, you can avoid paying capital gains entirely.
6. Be Self-Employed Without The FICA Tax
As a self-employed individual, you typically have to pay both the employer and employee portions of the FICA tax, which covers Social Security and Medicare. However, if you own rental property, the income you receive is not considered earned income. This makes you eligible for a little-known real estate tax benefit: exemption from the FICA tax, also known as the payroll tax.
Let’s crunch the numbers to see it in action:
Suppose you have a freelance writing business that generates $50,000 in revenue. As earned income, you would be liable for the payroll tax at a 15.3% tax rate, amounting to $7,650. However, if you were a rental property owner, you would be able to retain that amount in your bank account, as you would be exempt from the payroll tax.
Make Your Tax Breaks Count
Real estate investing offers numerous advantages, including various tax benefits, among others. If you’re considering a home as an investment, it’s crucial to get pre-approved first to ensure you have the necessary financial information to make a wise purchase decision.
We at Investment.org connect you with the best-in-class financial and investment advisors who analyze your goals based on your risk appetite and help you meet them. Our advisors work closely with you and provide the latest 1031 exchange property lists. This list lets you identify the right replacement property in less than three days.
Sign up to our portal today to access the free 1031 property list or talk to our advisors.
