To succeed in real estate investing, it’s not enough that you know how to purchase properties. You should also learn about executing smart strategies to lessen your tax bills, maximize your returns, and sustain the long-term growth of your real estate investments.
That is why in this blog, we will introduce you to a number of tax strategies and laws that successful real estate investors employ to lessen their tax burden. It will provide you with insights into practices like utilizing depreciation, exploring 1031 exchanges, and taking advantage of tax deductions, among others.
Remember, in real estate investing, knowledge truly is power – and it could also mean lesser taxes for you.
Armed with the right tax strategies, you can significantly reduce your tax burden and enhance the profitability of your investments. Check out the following tips and tax saving strategies below!
When you purchase an investment property, you can't deduct the entire cost of the property in the year you buy it. Instead, you write off a portion of the property's value each year or deduct depreciation. The Internal Revenue Service or IRS categorizes properties into residential (with a "useful life" of 27.5 years) and non-residential or commercial (39 years).
Suppose you buy a residential property for $275,000. The land it's on is worth $25,000, and the building itself is worth $250,000. You would divide that $250,000 by 27.5, giving you an annual depreciation deduction of $9,090.
This amount can be deducted from your ordinary income taxes each year for 27.5 years, effectively lowering the amount of tax you owe to the federal government. Just do your research especially on depreciation recapture when investing in real estate.
The Federal Insurance Contributions Act (FICA) tax is a U.S. payroll tax imposed on both employees and employers to fund Social Security and Medicare.
One of the advantages of real estate investing is that rental income is not typically subject to double FICA taxes. This is a substantial tax break since it avoids the hefty 15.3% employment taxes that apply to most other forms of earned income for self employed individuals.
Moreover, the IRS provides an exception for individuals who qualify as "real estate professionals." To meet this designation, you must spend more than half of your working hours in real property trades or businesses and also perform more than 750 hours of services during the tax year in real property trades or businesses.
Home equity represents the value of a homeowner's unencumbered interest in their real property. It's calculated by taking the current market value of the property and subtracting any existing liens like a mortgage payment.
Investors can borrow against this equity, using it as collateral for a loan. This strategy is often called a Home Equity Line of Credit (HELOC) or a Home Equity Loan.
The interest paid on these loans is typically tax-deductible when the borrowed funds are used to "buy, build or substantially improve" the income producing rental property that secures the loan. This makes the interest expense on a HELOC or home equity loan potentially tax-deductible if the funds are used to invest in more real estate or improve existing investment properties.
The mortgage interest deduction is another significant tax benefit for real estate investors. When you borrow money to purchase, build, or improve your new investment property, the interest you pay on the mortgage is tax-deductible. Even the borrowing costs can be deducted when paying taxes.
The tax law allows you to deduct the interest on up to $750,000 in mortgage debt. For investment properties, you can deduct the interest on loans used to acquire or improve the property.
In addition, if you own rental properties, you can also deduct the interest on loans used for personal purposes against your rental income, which can significantly lower your tax liabilities.
However, these deductions must be itemized, meaning they're only beneficial if they, along with your other itemized deductions, exceed your standard deduction.
Opportunity Zones were introduced as part of the 2017 Tax Cuts and Jobs Act to stimulate economic development and job creation in distressed communities. They offer potentially significant tax incentives for a real estate investor.
Investors can defer taxes on any prior gains invested in a Qualified Opportunity Fund (QOF) until the investment is sold or exchanged, or December 31, 2026, whichever comes first. If the QOF investment is held longer than five years, there's a 10% exclusion of the deferred gain. If held for more than seven years, the 10% becomes 15%.
Additionally, if the real estate investor holds the investment in the Opportunity Fund for at least ten years, they're eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.
This means you could potentially exclude all gains from tax on growth post-investment into the QOF.
If you want to avoid capital gains tax as one of your tax breaks, Section 1031 of the Internal Revenue Code provides a strategy for defer capital gains tax that might otherwise be incurred upon the sale of an investment property. It allows a real estate investor to sell a property and reinvest the proceeds in a new property and defer all capital gain taxes.
To qualify for a 1031 exchange, both the sold and purchased property must be held for use in a trade or business or for investment and must be "like-kind." The definition of "like-kind exchange" is broad; for example, you could exchange an apartment building for a strip mall. The new property should be of equal or greater value, too.
The process involves an intermediary who holds the proceeds from the sold property and then uses them to buy the replacement property within the required timeframes (45 days to identify up to three potential properties and 180 days to close on one of them) to avoid capital gains tax.
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-generating real estate. Investing in REITs provides a way to invest in real estate without the need to directly own property.
From a tax perspective, REITs have unique advantages. REITs are required to distribute at least 90% of their total taxable income to shareholders as dividends, which means consistent income for investors. While these dividends are taxed as regular income, for shareholders in low tax brackets, this could be beneficial.
Additionally, part of the dividend may be classified as a non-taxable return of capital, which reduces the investor's cost basis in the REIT. When the REIT is sold, this results in a higher capital gain, but that gain is deferred until the sale.
A Self-Directed Individual Retirement Account (SDIRA) is an IRA where the investor has complete control over the investment decisions. The account is administered by a custodian, but the account owner directs the investment types, including real estate.
With a Self-Directed IRA, you can invest in residential and commercial properties, raw land, and other forms of real estate. Income generated from these investments (rental income, real estate profits, etc.) flows back into the IRA tax-free or tax-deferred (depending on whether it's a Roth or Traditional IRA).
Similarly, property expenses (maintenance costs, capital improvements, property taxes) are paid with IRA funds, preserving the tax-advantaged status. However, strict rules prohibit personal use of the property or other "self-dealing" activities that are not for tax purposes.
This strategy allows for discounts when you pay taxes but requires careful management and a clear understanding of the IRS rules to avoid prohibited transactions that could lead to tax penalties instead of tax benefits.
As per the tax code, passive income refers to income from trade or real estate business activities in which the investor does not materially participate, like rental income from real estate.
The Tax Cuts and Jobs Act of 2017 introduced the pass-through deduction, also known as the Section 199A deduction, which potentially provide tax advantages to savvy real estate investors.
In essence, Section 199A allows eligible taxpayers or small business owners to deduct up to 20% of their qualified net business income (QBI) from a partnership, S corporation, or sole proprietorship, or personal taxes when they owe taxes. For real estate investors, rental income is often considered QBI, and thus eligible for the deduction from the tax bill.
This deduction is claimed on the investor’s personal tax return and can result in substantial tax savings. However, income limitations and other restrictions apply, making the application of this rule complex.
Another potent strategy is the use of the primary residence capital gains tax exclusion when investing in real estate or rental property. The IRS allows property owners to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains on the sale of their primary residence, provided they've lived in it for at least two of the past five years.
This can be an extremely effective tax strategy for those willing to convert investment properties into their primary residence to enjoy deductions on their long term capital gains.
By living in the property for the required amount of time, the investor can later sell the property and potentially exclude a significant amount or avoid capital gains tax when paying taxes.
The length of time you hold an investment property can impact the amount of tax you owe when you sell. This is due to the difference between short term capital gain and long term capital gain tax rates.
If you hold a property for less than a year and sell it for a profit, it would have short-term capital gains and are taxed at your normal income tax rate, which could be as high as 37% capital gains tax.
However, if you hold the property for more than a year, the long term capital gains are taxed at a significantly lower rate — 0%, 15%, or 20% long term capital gains tax, depending on your income.
For high-income investors, this strategy of holding properties for more than a year can result in significant capital gains tax savings. Although, this doesn't mean that the sale would be tax free when the time comes.
One strategic move for real estate investors seeking to mitigate their tax liability is to convert an investment property into their primary residence and live in it for at least two years. This can qualify the property for the primary residence exclusion when it's sold which can incur high tax benefits.
According to the IRS, if you've lived in the property for at least two of the last five years leading up to the sale, you can exclude up to $250,000 ($500,000 if married filing jointly) of the capital gains from the sale. This can represent a significant tax saving.
However, there are important rules to note. The property must be your primary residence, meaning you live there most of the time. You can't claim this exclusion if you claimed the same exclusion on a different property within the last two years.
An installment sale, also known as seller financing, is a strategy where the seller acts as the lender to the buyer. Instead of receiving the full sale proceeds at closing, the seller receives the purchase price over a period of time in installment payments.
This can be advantageous from a tax perspective because it allows for you to defer paying capital gains taxes.
The seller only pays capital gains taxes on the portion of the sale proceeds received each year, potentially spreading the tax liability over several years and possibly lowering the overall tax bill if the seller falls into a lower tax bracket in future years.
There are numerous potential tax benefits through deductions for real estate investors that can reduce taxable income. Remember that rental income is treated as regular income and is subject to income tax but through these deductions, you can get around the hefty taxes
These include not only the mortgage interest and depreciation discussed earlier but also property taxes, insurance, repairs and maintenance, property management fees, travel expenses related to the property, legal and professional fees, and even home office expenses if you manage the property from your home.
There are also potential deductions for startup expenses, for those just beginning their real estate investing journey, and for costs associated with obtaining a mortgage, such as loan origination fees, which can be deducted over the life of the loan.
The road to successful real estate investing isn't merely about buying and selling properties—it's also about understanding and managing your tax implications.
By integrating the tax strategies outlined in this article and seeking expert advice, you can form a comprehensive approach that will allow you to keep more of your hard-earned real estate investment profits.
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