In real estate investing, you have a lot of opportunities to significantly reduce tax liability to maximize profits and achieve financial freedom. These advantages that are often overlooked can be the difference between a good investment and a great one.
This comprehensive guide is designed to discover these hidden strategies within the tax code. Specifically, this blog will explore various tax benefits available to real estate investors, from depreciation and 1031 exchanges to opportunity zones and more.
With an understanding of these tax breaks, you'll be armed with the knowledge that can help you grow your business fast.
Understanding real estate taxation is critical when getting into real estate investing. As such, this section will detail the various types of taxes that investors may encounter, including real estate property tax, real estate income tax, net investment income tax, capital gains taxes, business income taxes, and individual income taxes.
This is a local tax that homeowners and real estate investors pay based on the value of their property. Local governments assess the property's value and levy taxes based on that assessment.
These funds typically go towards funding public services like schools, roads, and law enforcement. The tax rate can vary significantly depending on the location and the local tax laws.
This is the tax paid on income earned from real estate investments, which can include rental income or profits from the sale of real estate.
This income is usually taxed at your ordinary income tax rates, but there may be opportunities for tax deductions or credits related to the property.
The NIIT is a 3.8% tax that applies to individuals, estates, and trusts that have investment income above certain amounts. In the context of real estate, this might include rental income or income from the sale of a property.
These taxes apply when you sell an investment property at a profit. The tax rate depends on how long you've held the property.
Short-term capital gains tax applies to properties held less than a year and is usually taxed at ordinary income tax rates. Long-term capital gains tax applies to properties held more than a year and is typically lower than the ordinary income tax rate.
If you operate your real estate investments through a business entity, like an LLC, partnership, or corporation, you may be subject to business income taxes.
This could include income from rental properties or other real estate business activities. The specifics of these taxes can vary greatly based on the structure of your business entity.
Individual income taxes are imposed on your total income, including income from real estate investments. These taxes are assessed at your personal income tax rate.
As a real estate investor, you may be able to deduct certain expenses associated with your real estate properties, which can reduce your taxable income and, thus, your individual income tax liability.
You can definitely profit more from tax advantaged investments compared to those that are taxed regularly.
That said, this section will dive into the detailed tax benefits of real estate investors, including the tax deductions or write offs on rental income, capital gains, depreciation, passive income, pass-through deductions, and qualified opportunity zones.
Rental income from real estate is considered taxable income. However, real estate investors can avail themselves of several tax benefits that can significantly reduce their tax liability.
Note, however, that record-keeping is key when it comes to these annual tax deductions from your qualified business income.
Here are some of the most common deductions (qualified business expenses) for rental property owners aside from mortgage interest.
When real estate investors or rental property owners sell a property for a profit, the profit is known as a capital gain (a type of property tax), which is subject to capital gains tax. However, there are several tax benefits that can mitigate or defer capital gains tax as one of the tax benefits of real estate investing.
If an investor owns a property for more than a year before selling it, the profit is considered a long-term capital gain.
Long-term capital gains are taxed at a lower rate than short-term capital gains, which applies to investment properties held for less than a year. You can also defer taxes related to this when investing in real estate.
Named after Section 1031 of the U.S. Internal Revenue Code, a 1031 exchange allows investors to defer paying capital gains taxes (and other property taxes) and avoid depreciation recapture taxes when they sell a property, provided they reinvest the proceeds into a similar, or "like-kind," new investment property within a certain timeframe that has equal or greater value.
This can be an immensely beneficial strategy for investors who want to grow their portfolios and, at the same time, avoid paying capital gains or depreciation recapture on the profits from the sale as well as the purchase of a replacement property.
When a property is inherited, the cost basis of the property gets "stepped-up" to the fair market value at the time of the owner's death.
This means that when the inheritor sells the real estate investment property, they only pay capital gains tax or property taxes on the increase in value from the time they inherited the property, not from when the original owner purchased it. This can result in significant tax savings.
Depreciation is a substantial tax benefit for real estate investors. It allows them to account for the gradual wear and tear of a Federal Insurance Contributions Act property over time when investing in real estate and when they pay taxes.
According to IRS guidelines, residential rental property depreciates over a period of 27.5 years, and commercial real estate over 39 years. This means that each year, a portion of the property's value can be deducted as a business expense, effectively reducing the taxable income from the property.
For instance, if a residential property was acquired for $275,000, excluding land value, the investor can claim a depreciation deduction expense of $10,000 ($275,000/27.5 years) per year. This deduction can offset annual rental income and potentially turn a nominal profit into a loss for tax purposes, thereby lowering the tax bill.
A more advanced strategy to realize tax benefits, cost segregation involves hiring a professional to perform a study that identifies property-related costs that can be depreciated over a shorter time frame (typically 5, 7, or 15 years).
By accelerating depreciation in this way, investors can reduce their taxable income in the earlier years of investment property ownership, thus decreasing their tax liability.
The Tax Cuts and Jobs Act of 2017 introduced the concept of "bonus depreciation," which allows businesses to take an immediate first-year deduction on certain types of business property, including real estate.
Passive income is money earned from rental property, limited partnerships, or other enterprises in which an individual is not actively involved. The IRS treats passive income differently than active income, offering unique advantages to real estate investors.
One such advantage is the pass through tax deduction, introduced by the Tax Cuts and Jobs Act of 2017 (TCJA). A "pass-through" business is structured so that profits pass directly through to the owners' personal income without being subject to corporate income tax rates; hence the pass through deduction.
Many real estate investment entities, such as sole proprietorships, limited liability company or LLCs, and S corporations, are structured as pass-through businesses and can therefore use a pass through deduction.
Qualified Opportunity Zones (QOZs) are an economic development program established by the Tax Cuts and Jobs Act of 2017.
They were designed to stimulate economic development and job creation in distressed communities by providing significant tax benefits to investors who invest eligible capital into these zones.
The following are some of the opportunity zones from your qualified business income you can use for tax breaks.
Investors can defer paying taxes on capital gains that are reinvested in a Qualified Opportunity Fund (QOF), an investment vehicle designed to invest in QOZs.
The long term capital gains or property tax can be deferred until the QOF is sold or exchanged, or until December 31, 2026, whichever comes first.
If the investment in the QOF is held for longer than five years, there is a 10% exclusion of the deferred gain or property tax on the real estate investment property. If held for more than seven years, the 10% becomes 15%.
If the investor holds the investment in the Opportunity Fund for at least 10 years, the investor is eligible for an increase in basis equal to the fair market value of the investment on the date that the QOF investment is sold or exchanged.
This means that any appreciation in the value of the QOF investment would be tax-free when it's sold if the 10-year holding period is met.
Self-employment taxes are taxes paid by individuals who work for themselves and include Social Security and Medicare income taxes, collectively known as Federal Insurance Contributions Act FICA tax.
Normally, these taxes were split for the employer and employee portion, but self-employed individuals are responsible for the entire amount when paying taxes.
However, when it comes to real estate investing, certain strategies can help investors minimize their self-employment or payroll tax or FICA tax bill when they pay taxes.
Rental income is generally exempt from self-employment taxes unlike property tax. According to the IRS, if you're renting out investment property to a tenant and aren't providing substantial services other than the basic ones, such as heat and light, the income you make is not considered earned income for self-employment tax purposes.
This means that most landlords don't have to pay self-employment taxes on their rental income.
If you spend more than 50% of your working time in real property businesses and you perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate, you can qualify as a real estate professional.
This is a crucial distinction because, as a real estate professional, you can deduct rental real estate losses from other non-passive income. However, it's important to note that active participation as a real estate professional may subject some of your income to self-employment taxes.
If a real estate investor qualifies as a real estate professional and their business is structured as an S Corporation, there can be significant self-employment tax savings.
With an S Corporation, the investor can pay themselves a "reasonable salary" from their profits, which is subject to FICA taxes, and take the remainder of their profits as a distribution, which isn't subject to FICA taxes.
The key here is that the salary must be "reasonable" for the work performed, and what constitutes "reasonable" can often be a point of contention with the IRS.
These are retirement plans designed for self-employed individuals or business owners with no employees. Contributions to these plans reduce your taxable income now and grow tax-free until retirement.
Since the contributions for these tax deferred retirement accounts are made pre-tax, they lower your overall taxable income, which can result in the significant tax advantages of real estate investing.
Investing in real estate can provide a multitude of tax benefits that can significantly increase your return on investment.
From taking advantage of depreciation deductions and lessening or deferring capital gains through strategies like 1031 exchanges to leveraging passive income and pass-through deductions, there are numerous tax incentives available to you.
Now that you already know the tax breaks available to you as a real estate investor, you can start looking for the best deals. Be sure to check out Property Leads for highly qualified leads generated from SEO. We sell them exclusively to guarantee your success in real estate investing.
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