The Best Tax Benefits Of Real Estate Investing

Key Takeaways


What are the best real estate investment tax deductions?

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. In fact, Uncle Sam can become an investor’s best friend as there are a slew of real estate investing tax benefits available. The trick, however, is understanding what’s available and how to capitalize on it.


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Navigating real estate tax benefits

Navigating The Top Real Estate Investing 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:

  • Deductions

  • Passive Income & Pass-Through Deductions

  • Capital Gains

  • Depreciation

  • 1031 Exchange

  • Tax-Deferred Retirement Accounts

  • Self-Employment/FICA Tax

  • Opportunity Zones

Deductions

One of the biggest real estate tax benefits available for investors is in the form of deductions. These tax write-offs, which are 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. Because repairs keep a property in good condition and do not add value to the property, investors can write off repairs. Examples include fixing leaks, painting, and replacing broken parts of the rental property.

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 be able to deduct a portion of their home working expenses such as Internet and phone bill.

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. Most commonly, rental income. The Tax Cuts and Job Act that was passed in 2018 allows profitable businesses that earn qualified business income (QBI) to use a pass-through deduction. This allows investors to deduct up to 20 percent of their net business income thus reducing their effective income tax rate by 20 percent. It is currently available until 2025.

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.

  • 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.

  • 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. In addition, investors need to know about the capital gains exclusion, which is probably the biggest of all the 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 home. 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, and there are three factors that determine how much depreciation an investor can deduct each year. They include:

  • Their basis in the property (how much is the property worth?)

  • The recovery period for the property

  • 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 on a yearly basis.

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 successfully complete a 1031 exchange, investment properties must meet the following criteria:

  • The value of the replacement property must be equal to — or greater — than that of the resigned property.

  • Properties in the transaction must be exchanged for some type of asset, such as a real estate investment trust (REIT).

  • The exchanged property must be held for “productive purposes in business or trade.”

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). Certain accounts have annual contribution limits as well as 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 that is 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, depending on how you legally structure your real estate business, it can be offset.

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 most rural and distressed areas in the country. 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 be sure to check for any new changes.

Summary

Some of the greatest benefits of investing in real estate are the tax breaks that are available, but the barrier for many is being unaware of these opportunities and how to take advantage of them. Understanding which real estate tax investing 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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