The tax benefits of real estate investing might almost be as attractive to a would-be residential re-developer as the profit potential this career holds. That’s because, whether it’s real estate investment tax deductions or good, old real estate investing tax strategies you have your eye on, filing taxes becomes a lot more fun when you’re a real estate investor.
Which tax saving strategies for real estate investors can you take advantage of? How can being an investor really affect your income tax return? And what sort of positive boost to your state tax refund and federal tax refund can you see as a real estate investor?
Though we are not an accountancy firm, and you should certainly do your own due diligence to make sure you follow all relevant tax guidelines, here are three little-known tax benefits of real estate investing that you should put on your calendar, and plan for to help you come next tax season:
Understanding The Tax Benefits Of Real Estate Investing
As a real estate investor, you have the advantage of deducting certain costs and expenses every time you file your annual income tax. This includes:
This is probably the biggest deduction most taxpayers take advantage of, but it doesn’t just apply to an original loan on a primary residence. Investment property loans, refinanced mortgages, and home equity loans or lines of credit also apply.
When you receive your annual Form 1098 from your mortgage lender, whether it’s tax season 2017 or some other year, detailing all the interest you paid throughout the year, you’ll see which parts are deductible and how much. This deduction also applies to insurance premiums or any payment that went through an escrow account.
Almost all expenses you make to manage your property, and your real estate investing business, can be deducted from your tax bill. You can also deduct expenses for your home office (e.g. internet/phone bills, etc) or every trip you take to view a property.
Improvements differ from repairs, as the former improves your house’s overall value, prolonging its life. Improvements include roof replacement, re-doing the plumbing, adding another room (e.g. bedroom, bathroom, recreation room), kitchen makeovers, etc.
Repairs, on the other hand, are confined to work that keeps your property in an operational and efficient condition. Repairs include re-painting the walls, fixing gutters, repairing any leak, etc.
The tax code allows you to write off repairs immediately, as you would other expenses. While improvements that add value must be depreciated over years. This can give you a good set of tax benefits, in both the short-term and long-term, and help boost your bottom line.
The IRS takes into account possible wear-and-tear every building will experience as time goes by. It’s called depreciation of an asset, and if you’re an investor in rental properties, you can utilize this depreciation as a yearly tax write-off and reduce your tax liability.
How It Works
You’re able to deduct the depreciating value of a building over the course of several decades. For residential properties, it’s 27.5 years; for commercial properties, it’s 39 years.
For example, with a $200,000 residential property, you can write off 85% of that property’s value — land is usually 15% of a property’s value and you can never depreciate land — over the course of 27.5 years.
That 85% of the building’s value would translate to $170,000 of total depreciation, or $6,181.8 every year for the next 27.5 years, giving you a nice, tidy tax break for nearly 30 years.
Why It Works
Let’s say you earn $400 from that same property, per month, in rental income. Because of depreciation, you wouldn’t be paying tax on that income. You’ll be earning a total of $4,800 in rental income from your property, while your deductible tax will be $6,181.8. Though considered a “loss” on paper, you are actually earning money. Even though your building goes through natural wear-and-tear, the value of your property generally goes up with time, especially if you’ve invested in improving it.
In the investing trade, this is sometimes called a “Phantom Gain,” but there’s nothing otherworldly about it. It’s a fantastic strategy for reducing taxable income and building wealth.
3. 1031 Exchange
The 1031 exchange is basically a way for a real estate investor to delay paying taxes when they sell a property.
How It Works
When you decide to sell your property, you are required to pay taxes for your capital gains. However, per section 1031 of the Internal Revenue Code, there is an exception.
You are allowed to postpone paying taxes when you reinvest those gains in another property. In essence, you are exchanging your old property for another real estate property. Simply put, you are investing in your future with tax-free income.
To qualify for this, the new property must meet the following criteria:
- The Like-Kind Exchange: The new property must be of the same character, nature, or class. Meaning, you can’t sell a residential property, only to purchase a set of franchises. The value of the new property should be equal to or greater than the old property.
- Time-sensitive investment: Within 45 days of selling, you need to identify a replacement property, specified in official documents. Afterwards, you only have 180 days after the sale of the old property to close the deal on the new property.
- A qualified intermediary: With the 1031 Exchange, you cannot handle the money, nor transactions, on your own. You need an intermediary to do so, and this person cannot be anyone you’ve worked with in the past two years (e.g. real estate agent, broker, investment banker, lawyer, accountant, or employee).
Failure to meet these criteria will disqualify you from the 1031 exchange and would hold you liable to pay taxes on your property sale gains.
Why It Works
Savvy real estate investors use this to postpone paying their taxes (e.g. 25% depreciation recapture). Another great feature is you get to invest 100% of your profit from selling the old property into buying a better, higher-valued property.
This strategy has the potential to reap you larger profits, given you do it properly. Careful handling, however, is paramount to this strategy.
“This Is Only the Beginning…”
We haven’t even scratched the surface when it comes to the tax benefits of real estate investing. A self-directed IRA and long-term capital gains are other great ways to reduce your tax bill, while building wealth as a real estate investor.
If you haven’t quite made the leap to become a real estate investor, it’s possible to generate income and decrease your tax liability at the very same time. By purchasing, renting, and eventually selling property, you’ll gain new leverage (and appreciation) for what your money can do for you. especially when it comes to helping you keep more of what you earn.