There are a number of measurable benefits associated with investing in real estate. In addition to real estate's potential to provide a recurring cash flow and diversify your portfolio, there are potential tax benefits that can help you generate even more wealth.
What are the Tax Benefits of Investing in Real Estate?
Here are eight ways you could save money on taxes as a real estate investor:
Real estate investors with income-producing rental properties can deduct depreciation on their taxes to lower total taxable income and reduce tax liability.
For commercial properties, the IRS allows a property owner to take depreciation deductions for 39 years, and for residential properties, the deduction could extend 27.5 years. If you purchase a residential property for $250,000 to rent out, you could take a $9,091 deduction ($250,000 divided by 27.5) for depreciation each year.
When you make major improvements to a real estate investment property, you may be able to take deductions for the depreciation, as well. If you decide to sell the property, you'll pay the standard income tax rate on all depreciation you've claimed over the years.
It's possible to avoid depreciation recapture through several tax strategies:
- 1031 tax-deferred exchange where a rental property is sold and replaced by a like property within 180 days
- Convert a rental property to a primary residence and live there for at least two years
- Deduct sales commission and closing costs from the cash received from the sale of property
Deductions reduce your taxable income dollar-for-dollar. If you for example receive $30,000 throughout the year as rental income and your deductions add up to $14,000, your total taxable income is $16,000.
Individuals may also receive tax breaks on business-related deductions when they participate in real estate investments through a limited liability company or limited partnerships. Many business deductions are a percentage of the total expense. Certain costs are deducted at face value, however. Capital improvements are depreciated over time. Other deductions include:
- Business miles: $0.56 per mile if you don't claim depreciation on the vehicle
- Business-related travel: Actual expenses including car rental, train fare, airfare, parking fees, and tolls
- Business gifts: $25 or less, not including gifts that could be considered entertainment (concert tickets, etc.)
- Business meals: 100% of business meals in 2021 and 2022
3. 1031 Exchange
1031 exchanges allow you to defer paying capital gains taxes on a property when you sell if you subsequently purchase an investment property of equal or greater value. There's no limit on how many times you can use a 1031 exchange, but when you eventually cash out and sell your property, you'll pay capital gains tax.
You must exchange business or investment property, although in some cases you can swap a former primary residence. Both properties must be located in the United States. Only real property (not equipment, corporate stock, aircraft, etc.) is eligible for a 1031 exchange. If you want to sell your interests in an investment as a tenant in common (TIC), your property swap is eligible for a 1031 exchange provided you meet all other IRS requirements.
Here are the timing rules imposed by the IRS:
45-day rule: Cash received from a property must go directly to an intermediary. Within 45 days of the sale, you must designate a replacement property and provide the intermediary with written notice of the designation.
180-day rule: Closing on the new property must occur within 180 days of the sale of your previously owned property. The 180-day time period runs concurrent to the 45-day time period.
4. Opportunity Zones
Opportunity Zone funds provide real estate investors with a means by which to reinvest money from the sale of a real estate property to reduce capital gains taxes. The new Opportunity Zone program includes residential rental property businesses, so real estate investors who are just starting out and may own a single rental property can take advantage of the tax benefits as they grow their rental property business.
The U.S. Department of Treasury designated certain disadvantaged areas of the country as Opportunity Zones to encourage investors to provide economic support. Investing unrealized capital gains into a Qualified Opportunity Fund provides financial support to struggling communities while allowing investors to enjoy tax breaks. If you invest in a Qualified Opportunity Fund, you'll enjoy these benefits:
- Grow capital gains by 10% if you stay invested in the fund for five years, 15% if you wait for seven years
- Defer capital gains taxes until 2026 or until you sell your investment in the fund
- Avoid capital gains taxes if you stay invested in the fund for at least ten years
5. Passive Income and Pass-Through Deductions
Until 2018, passive income (defined by the IRS as money earned from real estate activity that the business owner doesn't materially participate in) couldn't be offset unless the business owner also had passive losses. Now, some rules allow real estate investors to deduct a portion of their rental income from their taxable income through what the IRS refers to as a "pass-through deduction."
Under this rule, real estate investors may be able to deduct 20% of their qualified business income (QBI) automatically. Money collected from rent if you own property through an LLC or S-Corp, is a sole proprietor, or have a partnership is all considered QBI. Certain dividends, capital gains, and losses, and interest income do not qualify. This pass-through deduction is a perk of the Tax Cut and Jobs Act of 2017 and is set to expire in 2025.
6. Capital Gains Tax Vs. Ordinary Income
When a real estate investor sells a property for more than they originally paid, the difference may be taxed as a short-term or long-term capital gain, which has a lower tax rate than income tax.
If you held the property for fewer than 365 days, the short-term capital gains tax rate ranges from 10% to 37%, depending on your tax bracket. If you held the property for one year and one day or longer, long-term capital gains tax rates range from 0% to 20%, depending on your tax bracket. So, if you can hold a property for at least one year plus one day and your regular yearly income is low enough, you may pay 0% tax on your profit from selling a rental property.
7. Tax-Free or Tax-Deferred Retirement Accounts
There are many ways to invest in real estate aside from owning and renting out property. Investing in alternative assets through your health savings account (HSA), individual retirement account (IRA), Solo 401(k), SEP IRA, or Self-Directed IRA means your investment may grow tax-deferred or tax-free. Adding real estate investment funds to your portfolio in a tax-advantaged account is one way to gain exposure to this potentially lucrative sector without increasing your tax bill.
8. FICA Tax Breaks for Self-Employed Real Estate Business Owners
Self-employed taxpayers must pay 15.3% of their earned income for Federal Insurance Contributions Act (FICA) taxes, also known as the payroll tax. If you have an employer, they are responsible for paying half of your FICA taxes. Since money earned from rental income isn't classified as earned income, real estate property owners with rental income aren't responsible for making FICA contributions.
Tax Benefits & Gatsby Investment
Real estate investors realize many advantages beyond tax breaks. If becoming a landlord isn't how you prefer to get involved in real estate, you still have several potentially lucrative options that provide significant tax benefits.
Contact us today to learn more about how Gatsby Investments could help you get involved in exciting and potentially lucrative real estate investments.