Top 6 Tax Benefits Of Real Estate Investing
Top tax benefits to be enjoyed from real estate investing include, but are not limited to, the following.
1. Deductible Expenses
Many common costs incurred by real estate investors qualify as deductible expenses that can be claimed on your taxes. This means that you won’t have to worry about paying government-imposed taxes on these expenses.
In fact, some aspiring real estate investors even use the process of house hacking to compound deductible benefits, as homeowners can enjoy access to additional tax write-offs when they invest with their primary residence. Just a few of many common tax-deductible expenses that you can potentially tap into as part of real estate investing depending on your property ownership and business dealings include:
If you have questions about which expenses may be tax deductible, consult with a qualified tax professional. You may be surprised at just how much money that you may be entitled to write off.
The practice of depreciation helps account for wear, tear and degradation that occurs on a property over time. In effect, it provides a means for helping real estate investors take tax deductions on rental properties, which inevitably suffer negative effects of usage over a prolonged period of years.
Depreciation is determined by calculating the useful time frame (aka useful life) of the property and applying a formula to compute how much value is lost each year. Once done, you can claim the annual deduction on your taxes, which can help lower your taxable income.
To calculate property depreciation, start by determining your cost basis in the property, dividing it by the property’s useful life and computing a depreciation schedule. Once this schedule has been calculated, you can use it to compute and secure annual tax deductions.
When selling your property, be aware of a practice known as depreciation recapture. In essence, when you apply depreciation to a property, it lowers your cost basis in the investment holding. At the time you sell the property, the IRS will calculate capital gains tax based on a profit margin that reflects this new cost basis − an example of depreciation recapture at work.
Say you purchase a new property for $250,000, and then apply $50,000 in depreciation, causing your cost basis to become lowered to $200,000. If you were to then sell the property for $300,000 at a later date, the IRS would calculate your capital gains tax using a profit margin of $100,000 instead of $50,000.
3. Passive Income and Pass-Through Deduction
Under the terms of the Tax Cuts and Jobs Act of 2017, a helpful tax deduction was created for real estate investors, small business owners and self-employed professionals. This deduction is known as the Qualified Business Income (QBI) deduction, or pass-through tax deduction in common parlance.
Per the QBI, qualifying parties can receive up to a 20% deduction on income received from pass-through business entities such as partnerships, sole proprietorships, S-corporations and limited liability companies (LLCs), like on qualified rental income. Real estate income received in such a fashion is often classified by the Internal Revenue Service (IRS) as passive income, even though it can take considerable work to bring in tenants and rental money on a recurring basis.
As such, you may be eligible for further tax-saving benefits and deductions depending on the type of property that you own and how it operates.
4. Capital Gains Tax
If you’re currently involved, or considering diving into, the world of real estate investment, you’ve no doubt heard capital gains tax mentioned. Essentially, whenever you sell an asset that grows in value, you may be required to pay taxes on the profits realized from that investment − single-family homes, multifamily residences, apartment/condo buildings and other properties included.
Capital gains tax is generally applied to appreciation on your investments, but can also vary depending on how much you earn, how long you’ve owned the asset and your tax filing status.
For example, if your taxable income is under certain present thresholds, capital gains tax may range from 0% – 15%, or jump to 20% if your taxable income exceeds these thresholds. It also depends on how long you have held the assets. Here’s a breakdown of the difference between short and long-term capital gains.
Short-Term Capital Gains
Short-term capital gains are profits that you’ve earned on assets that you’ve had in your portfolio of investment holdings for 12 months or less. These capital gains can have a negative impact on your taxes, as they’re treated as general income and taxed at your marginal tax rate (aka according to your current tax bracket). If a year passes before you sell the asset and recognize these gains though, any profits would be considered long-term capital gains instead.
Long-Term Capital Gains
Long-term capital gains speak to profits recognized from assets that you’ve held for a minimum of one year or more. Earnings realized as long-term capital gains are taxed at a lower tax rate than those derived from short-term capital gains, generally being billed at a rate of 15 – 20% vs. marginal tax rates. If you can, it generally pays to hold onto investments a little longer as a result of these savings opportunities.
5. Incentive Programs
Real estate investors, depending on how they structure their property ownership and portfolio of holdings, may also be eligible to capitalize on various tax incentive programs. These incentive programs allow you to recognize added tax savings on qualifying investments and income, though limit eligibility accordingly as well.
The 1031 exchange allows you to sell one business or investment property and purchase another without subjecting yourself to capital gains taxes. However, the exchange must be properly completed and conducted per IRS rules. Your new property must be of the same nature as the original, and of equal or greater value than the property sold.
A 1031 exchange effectively allows you to swap real estate investment out in place of another and defer taxes on capital gains. Note that using a 1031 exchange only lets you put off payment to a later date − not reduce your tax bill or avoid paying taxes entirely.
Created via the Tax Cuts and Jobs Act of 2017, opportunity zones are a way the government encourages individuals and businesses to invest in certain communities to promote economic growth.
These geographic regions have been identified as low-income census areas and targeted for job growth and economic stimulus. Real estate investors can capitalize on opportunity zones by rolling qualified capital gains into an opportunity zone fund within 180 days of the sale of an asset.
Tax-Free or Tax-Deferred Retirement Accounts
Select tax-free and tax-deferred retirement accounts (for example, some 401(k) plans and Roth IRAs) may provide opportunities for you to invest in alternate assets beyond stocks and bonds. These opportunities can include private or commercial real estate, real estate investment trusts (REITs) and other property-based holdings.
However, tax-deferred and tax-free retirement accounts often come with savings contribution limits and requirements attached that vary by account. Before applying for one, you’ll want to consult with a qualified financial professional to determine to what extent, if any, these accounts can help you lower your tax burden.
6. Self-Employment FICA Tax
Per the Federal Insurance Contributions Act (FICA), self-employed individuals are responsible for the 15.3% of Social Security and Medicare income taxes. However, while rental income is taxable to some extent under standard income guidelines, it is not subject to FICA taxes.
Filing a Schedule E tax form makes the IRS aware of how much rental income you’ve earned, and how taxes should be applied here. While Schedule E income is generally not subject to self-employment taxation, certain types of rental activities may trigger self-employment taxes, making it important to be aware of as a real estate investor.