Investing in real estate provides many benefits: income generation, appreciation, diversification…the list goes on and on.
One of the least understood benefits of real estate investing is the tax breaks.
Tax breaks reduce your tax liabilities and improve your bottom line by allowing you to keep more of your money.
And there are several tax benefits of real estate investing. This article will break them down for you and show you how to use legal tax breaks to legitimately improve your investment profits.
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.
1. Depreciation
Real estate investors with income-producing rental properties can deduct depreciation on their taxes to lower total taxable income and reduce tax liability.
For a complete lesson in how this works, read our article about rental property depreciation. Here is a brief overview.
Depreciation is the theoretical declining value of a structure due to normal wear and tear over decades. The IRS allows investors to deduct the value of the depreciation from their annual taxes using a depreciation schedule.
For commercial properties, the IRS allows a property owner to take depreciation deductions for 39 years. For residential properties, the deduction could extend to 27.5 years. For example, if you purchase a residential rental property for $250,000, 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 sell the property for a gain (which is the typical outcome), the IRS is entitled to “depreciation recapture.” This means you have to repay the depreciation you've claimed over the years. However, it is possible to avoid some (or all) of 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 (more on this coming up)
- 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 the property
2. Deductions
Deductions reduce your taxable income dollar-for-dollar. For example, if you receive $30,000 throughout the year as rental income and your deductions add up to $14,000, your total taxable income is $16,000.
Common investment property deductions include:
- Property taxes paid
- Mortgage interest paid
- Operating expenses
- Repairs and maintenance
Note: capital improvements (enhancements made to a property that increase its value, extend its life, or adapt it for new uses) are not immediately deductible, but you can use depreciation deductions on the capital improvements.
If you participate in real estate investments through a limited liability company or limited partnership, you may also receive tax breaks on business-related deductions. For example, if you travel to manage, maintain, or check on the rental property, you can deduct expenses related to airfare, vehicles, and hotel stays.
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.
Both the relinquished property and the acquired property 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 with the 45-day time period.
4. Opportunity Zones
Investors who contribute to Opportunity Zone Funds can defer capital gains while supporting distressed communities.
The U.S. Department of Treasury designated certain disadvantaged areas of the country as Opportunity Zones to encourage investors to provide economic support. According to the IRS, Opportunity Funds Investors receive the following tax benefits:
Tax benefit on temporary deferral
- If you hold your investment in the Qualified Opportunity Fund for at least 5 years, your basis (the amount of your investment) will increase by 10% of the deferred gain.
- If you hold your investment in the Qualified Opportunity Fund for at least 7 years, your basis (the amount of your investment) will increase by an additional 5% of the deferred gain.
Adjustment to Basis After 10 Years
- If you hold your investment in the Qualified Opportunity Fund for at least 10 years, you may be able to permanently exclude gain resulting from a qualifying investment when it is sold or exchanged.
- The exclusion occurs if you elect to increase the basis of your Qualified Opportunity Fund investment to its fair market value on the date of the sale or exchange.
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, are 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 profit is taxed as capital gains.
- 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 just 0% to 20%, depending on your tax bracket.
So, if you can hold a property for at least one year plus one day, your profits will be taxed at a much lower rate.
7. Tax-Free or Tax-Deferred Retirement Accounts
Retirement accounts offer tax benefits. Some account types allow you to contribute after-tax dollars, and then withdraw your funds tax-free during retirement. Other account types allow you to invest pre-tax dollars (giving you more capital early so your interest can compound over time), and then pay income taxes on the amounts you withdraw during retirement.
With a self-directed retirement account, you can hold alternative investments, including real estate, within your tax-advantaged retirement account.
If you don’t have a self-directed retirement account, you can still invest in real estate-based securities (like real estate mutual funds, ETFs, and REITs) through your more traditional retirement accounts.
Learn more about investing in real estate with your IRA or 401(k).
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 aren't responsible for making FICA contributions from their rental income.
Tax Benefits & Gatsby Investment
Gatsby Investment is a real estate company that offers syndication deals to investors. Real estate syndication is when you pool funds with other investors to access unique deals and share in the profits.
The model is similar to crowdfunding, but syndication offers a more stable legal ownership structure, in which investors own an equity stake in the underlying real estate. This ownership stake entitles you to many of the tax benefits of real estate investing outlined above!
Plus, as a syndicate investor, you do not have to invest any of your own time or energy acquiring, maintaining, and operating real estate investment properties. Our experienced team handles every detail of the project for you.
You can explore our investment offerings online or contact us to learn more about how Gatsby Investments can help you get involved in lucrative real estate investments with tax breaks!