How to Pay Less Taxes: A Real Estate Investor’s Guide

Key Takeaways


Taxes are a major challenge for real estate investors because they can siphon a large percentage of an investor’s profits. Veteran real estate professionals learn how to pay less taxes on their investments and are pretty good at incorporating tax planning into their overall investment strategy.

Are you just getting started in real estate? This guide will cover some basic strategies you can use to reduce your tax burden and boost your profits.

10 Ways to Pay Less Taxes on Real Estate

There are 10 ways to can pay less taxes on real estate:

  1. Own Properties in a Self-Directed IRA

  2. Hold Properties Over a Year

  3. Avoid FICA Taxes

  4. Defer Taxes with 1031 Exchange

  5. Use Installment Sales

  6. Deduct Mortgage Interest

  7. Use the 20% Pass-Through Deduction

  8. Claim Depreciation Deduction

  9. Borrow Against Home Equity

  10. Tally Every Expense

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1. Own Properties in Self-Directed IRA

You’ve probably heard of an IRA. An IRA is a popular retirement fund in which you steadily contribute money to an investment that will ultimately fund your retirement. When you open an IRA, you get to choose which investment your money will go into. The best part about an IRA is that you don’t have to pay taxes on your contributions right away. Instead, you only pay taxes when you withdraw money from your IRA after you’ve retired (unless you opened a Roth IRA—which works in the opposite way).

You can use an IRA account to fund real estate investments without paying immediate taxes on the sale. This is known as a “self-directed IRA.” This method of real estate investment works best when you’re paying for a property in cash.

Let’s say that you want to purchase a property. First, you’ll need to create a legal entity that will buy, own, and sell rental properties. Many real estate investors choose an LLC.

Then, you’ll pay a custodian or trust to open an IRA account for you, and you’ll choose your LLC as your chosen investment fund.

When you’re ready to buy a property, you’ll transfer the funds into your IRA. Then your LLC can use those funds to complete the transaction. Since you’re technically contributing money to a retirement fund, you don’t have to pay taxes on the purchase—until you retire.

This method is harder to do if you need to finance a property. Your loan must be a “non-recourse” loan, which means you won’t be liable if the loan defaults. But many lenders will refuse to grant those types of loans.

If you’re able to secure financing, only your down payment and principal are sheltered from taxes. The financed portion of the property is still subject to taxes.

With a self-directed IRA, the same rules apply as with a traditional IRA. You can’t withdraw money until you’re 59 1/2, and you must start withdrawing when you’re 70 1/2.


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2. Hold Properties Over a Year

One of the easiest ways to reduce your tax burden is to hold a property for at least one year.
If you’re a house flipper, you might want to buy and sell properties as fast as possible. But it can actually be more profitable to hold your properties for at least a year before selling.

When you own an asset for less than a year and sell for profit, the IRS considers you a “dealer.” Short-term buying and selling is considered a business. And since you’re a business, you must pay FICA taxes—taxes set aside for Medicare and Social Security.

Furthermore, the sale of the property will be taxed as personal income instead of capital gains—which is far higher.

It’s okay to sell one short-term property per year, but if you’re going to sell two or more, then you’ll almost certainly be classified as a “dealer” for tax purposes, and you’ll also incur the higher personal income tax rate.

All you have to do to avoid these taxes is to hold your properties for more than a year before you sell. If you are house flipping, you should be able to find hard money loans that don’t need to be repaid for 1-2 years.

If you’re in a financial crunch, you can always rent out your fix-and-flip before you sell. Rent it out to tenants and use the money to start paying off your hard money loan. Make sure you only offer a short-term lease so you can sell the property within two years.

As long as you hold a property for a year or more, you can avoid FICA taxes and ensure the sale is taxed at the lower capital gains tax rate.

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3. AVOID FICA Taxes

As mentioned in the last section, the IRS will make you pay FICA taxes if they consider you a self-employed real estate investor. However, you can avoid these taxes if you demonstrate “investment intent.” In other words, you’re showing the IRS that you’re only trying to generate capital for other investment projects and that it’s not a standard business practice for you.

These investment projects may include:

  • Making renovations on a property

  • Making a down payment on a long-term rental

These types of projects show the IRS that you’re focused on doing long-term investing and that you’re not trying to do short-term investing for immediate business revenue.

It can be difficult to prove “investment intent,” so it’s always best to consult with a tax attorney before using this strategy.

4. Defer Taxes with 1031 Exchange

Section 1031 of the tax code allows for a “like-kind exchange,” in which you can defer paying taxes on a property sale for an indefinite period. All you have to do is buy a similar property with proceeds from the sale.

If you sell a property and make a profit of $100,000, you can defer paying capital gains if you use the $100,000 to purchase another property (the $100,000 will be used for the down payment).

There are some rules that govern 1031 exchanges:

  • You need to hire a qualified intermediary to facilitate the transaction

  • You must provide the intermediary with a list of possible properties for the replacement property no later than 45 days after the sale of the original property

  • You must purchase a qualifying replacement property within 180 days of selling the original

  • Value of replacement property must be equal to or greater than your original property

  • The original and replacement properties must be investment properties—neither can be your primary residence

This is an excellent strategy if you don’t plan on selling the replacement property. Hypothetically, you could keep the replacement property your entire life and generate profit by renting it out to tenants. You’d never have to pay capital gains tax.

5. Installment Sale

What if you earn a profit on a sale, but you don’t want to use the proceeds to buy a new property? In that scenario, you’d have to pay capital gains tax, and you could potentially be faced with higher income tax.

Some investors prefer to sell a property using seller financing. With seller financing, you’re providing a loan to the person that’s buying your property.

You’ll only have to pay taxes on the buyer’s down payment and principal (closing costs), but you don’t have to pay capital gains tax because you didn’t receive all the money upfront. Instead, the buyer is paying you the outstanding balance over time. You also get to earn interest from the buyer, so seller financing can be hugely profitable.

Of course, seller financing is very risky. If the buyer defaults, the foreclosure will fall on you because you still have some—if not most—of the equity in the property.

Make sure you thoroughly bet the buyer before you offer them seller financing. It’s also a good idea to start with a lease-purchase agreement. Under this type of agreement, the buyer starts as a renter and part of their rent goes toward a down payment on the home. After the buyer has paid a stipulated amount toward the down payment, you can transfer the property and sign a mortgage note.

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6. Deduct Mortgage Interest

Many expenses in real estate are tax-deductible. Here are some of the tax deductions you can claim in real estate:

  • Mortgage insurance

  • Home insurance

  • Property taxes

  • Property management fees

  • Advertising expenses

  • Legal fees

  • Maintenance costs

  • Home office expenses

  • Travel expenses for business

What’s great about these tax deductions is that you don’t necessarily have to itemize your deductions to claim them. You can claim the standard deduction and also claim deductions for many of the expenses listed above. Claiming these deductions can significantly reduce your tax bill.

A word of advice: be honest and don’t push it. If you’re going to buy a personal laptop, don’t try to write it off as a business laptop. The IRS may get suspicious if there are too many questionable expenses, which might prompt them to run an audit.

7. 20% Pass-Through Deduction

Small business owners can deduct an extra 20% of their net business income. This is known as the 20% pass-through deduction.

This tax deduction is meant for small businesses, so there are income limitations: $315,000 for married couples and $157,000 for single filers.

It may be helpful to consult a tax expert if you’re not sure whether or not you can claim this deduction.

8. Use Depreciation Deduction

Properties tend to depreciate because of natural deterioration and wear and tear. Therefore, the IRS allows you to claim depreciation for each of your investment properties.

The IRS sets the lifespan of a residential building at 27.5 years so that you can deduct 1/27.5th of a property value each year for the first 27.5 years of a property.

For example, if your property is valued at $500,000, then you can claim a tax deduction of $18,181 for the first 27.5 years you own the property. (500,000 / 27.5)

You can also depreciate appliances and fixtures over 15 years, and also property improvements. So if you spend $5,000 on renovations, you can deduct $181 per year for 27.5 years. (5,000 / 27.5)

There’s a major caveat: if you claim depreciation, you may also owe taxes on depreciation recapture if you sell the property for a profit. This is because the IRS wants you to pay back the taxes you avoided from depreciation claims.

You can avoid depreciation recapture if you sell the property for a loss, or if you don’t sell the property at all.

For that reason, you might only want to claim depreciation on a property that you’re going to hold long-term.

9. Borrow Against Home Equity

Acquired lots of equity in a property? You can pull out equity from your property and use the money to finance another real estate investment.

Some investors might choose to sell the property and use the proceeds to finance a new investment—but this may incur capital gains tax. When you borrow against home equity, you can keep your property, avoid paying capital gains and gain income to finance a new investment.

Most lenders will allow you to extract 80% to 85% of your home equity. There’s some risk involved because you’re losing equity in the property and accruing more debt, but you can mitigate this risk by renting out your property to tenants. You can use the rent income to pay back the equity you’re borrowing from the property.

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10. Tally Every Expense

As you might have realized, it’s harder to develop a tax strategy when you’re not keeping track of all your real estate expenses. Keep thorough records of all your expenses, especially if you want to claim tax deductions.

Many real estate apps that can help you keep track of your expenses and even help you prepare for your annual tax filing. Be sure to add one or two of these apps to your real estate investment toolbox.

Passing Away With Real Estate

For tax purposes, what happens if you pass away when you own real estate?

If you own property when you pass away, your “original basis” on the property disappears. In other words, the original price you paid on the property is no longer a factor. Additionally, your heirs do not have to pay capital gains on the property.

Soon after you die, your properties will be reassessed and given a new market value. If your heirs decide to sell the property, they don’t have to pay capital gains on any profit made from the sale.
Let’s say you originally paid $300,000 for the property. When you die, the property is assessed and given a value of $500,000. Your heirs sell the property for $550,000.

Under normal circumstances, there would be a capital gains tax on $250,000. But not if you died. Your heirs can keep the $550,000 profit without having to pay any capital gains.

Your heirs may have to pay estate tax if you’re wealthy—only the first $11.8 million of your estate is tax-free. Otherwise, your heirs will have little tax obligation, especially if you’ve acquired full equity in your properties.

Summary

You can increase your real estate profits if you learn how to pay less taxes on your investments. There are 10 ways you can boost your real estate tax savings: 1) Own properties in a self-directed IRA 2) Hold properties for over a year 3) Avoid FICA taxes 4) Defer taxes with a 1031 exchange 5) Use installment sales 6) Deduct mortgage interest and expenses 7) Use the 20% pass-through deduction 8) Claim depreciation deductions 9) Borrow against your home equity 10) Tally all your real estate expenses. Want to know what to do with your properties after you retire? If you choose to keep your properties, your heirs will have to pay no capital gains tax if they sell for a profit. Consider reducing your estate size to below $11.8 million if you want your heirs to avoid paying the estate tax.


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