“What can I do to get the most out of my real estate investment?”… A question that most property investors ask.
Notably, the real estate industry is one of the most popular and lucrative business in the world. That’s because there are so many ways to make money from it.
Property investors make money through renting, leasing, capital gains, equity capture, fix-and-flips, tax benefits, and so on.
However, out of all these income generating streams, real estate tax benefits are always the least understood.
Luckily, this post highlights a few real estate tax loopholes that property investors – especially those new to the industry – should take advantage of.
A Few Common Tax Benefits for Real Estate Owners
When it comes to making use of tax loopholes in the property market, investors need to know what to do and how to do it right.
This is the main reason why some investors devote a lot of time and effort to come up with solid real estate investment tax strategies. It not only helps them learn about investment property tax laws and benefits but also helps to save cash in the process.
So, here’s a breakdown of all benefits of investing in real estate:
1. Real Estate Investment Tax Deductions
Arguably, real estate tax deductions offer the biggest benefits for investors. Now, you might be wondering: What are tax deductions?
Basically, deductions are tax write-offs that are mostly applicable to rental properties. These involve incentives for property-related transactions such as property tax, mortgage interest, depreciation, repairs, and operating expenses.
So, what does this mean? Or how does this work?
Fundamentally, real estate tax deductions come in many forms including:
- Write-offs on expenses incurred during the management, conservation, and maintenance of a piece of property.
These expenses include property taxes, utilities, advertisement fees, insurance, and mortgage interest.
- Write-offs on repair costs since repairs only keep the property in pristine condition, but never raise its value.
Repair costs include fixing appliances, plumbing, HVAC systems, and broken windows/doors among other types of repairs.
- Also, mortgage interest on primary – sometimes secondary – homes can also be written-off; but only if it’s a home purchase or new mortgage refinancing.
2. Real Estate Depreciation Tax
Like all other types of assets, properties also lose value with time. This, in turn, provides a huge tax shelter for property investors.
Generally, the IRS stipulates that depreciation deductions should be made to cover wear and tear or exhaustion of a piece of property.
This means that as time goes by, a property owner’s tax burden reduces. This is great, right? Now, to properly determine how much depreciation occurs over a given time there are three factors to consider:
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The depreciation method used
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Property’s recovery period
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The property’s worth
Notably, the Modified Accelerated Cost Recovery System (MACRS) is the most popular depreciation method. Moreover, the IRS allows depreciation write-offs for 27.5 years (residential properties) and 39 years (commercial properties).
For example:
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IA property makes $20,000 taxable rental income.
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Taxes owed without depreciation = $20,000 x 25% federal income tax = $5,000
While...
- Taxes owed with depreciation = ($20,000 – $12,000) x 25% federal income tax = $2,000, where 12,000 is an example depreciation expense.
Therefore, in this case, there would be a $3,000 save after deductions on depreciation.
Regardless of whether the property is making profits, real estate depreciation is always considered a loss. That’s why property owners are allowed to make deductions on depreciation while at the same time deducting the cost of running and maintaining the property.
3. Capital Gains
You’re probably wondering: What are capital gains and how do they benefit real estate investors?
Capital gains are profits made from the sale of a piece of property. These profits fall into two main categories:
- Short-term Capital Gains
These taxes apply to properties held for less than a year. Unfortunately, this option doesn’t come with any special tax incentives.
- Long-term Capital Gains
These real estate investment taxes apply to properties held for more than a year; mostly rental properties. Here, the tax rates are more favorable to investors since they are lower than those of short-term capital gains.
Therefore, the only way to score big in tax savings is through long-term capital gains.
Think about it: Coupling long-term capital gains with all the other deductions increases an investor’s tax benefits. Moreover, property owners can use capital gains exclusions. This exempts them from having to pay taxes on property sale profits of up to $500,000.
4. The 1031 Exchange
This is yet another great tax benefit for real estate investors. Basically, a 1031 Exchange involves the swapping of one property for another. It’s mentioned under Section 1031 of the Internal Revenue Code.
So, how does this benefit property owners? Well, 1031 Exchange swaps come with no – to little – tax obligations. Therefore, investors can pass on capital gains from one property to another without having to pay taxes.
But the 1031 Exchange tax benefit has its fair share of conditions that have to be met. These conditions include:
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The swapped property has to be used for “productive reasons in business.”
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The replacement property must be valued at an equal – or higher – price than the one being resigned.
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Both properties must be swapped for some kind of asset e.g. a REIT (Real Estate Investment Trust).
5. FICA or Self-Employment Tax
FICA or the Federal Insurance Contributions Act is a 15.3% tax on a person’s employment income.
Basically, if the investor is employed, their FICA tax obligation is split into two between them and their employer. This means that they only get to pay 7.65% of their salary as tax.
On the other hand, self-employed investors often pay the tax in full – 15.3% of their salary. So, where do the tax benefits of real estate investing lie in this?
Well, FICA taxes do not necessarily apply to rental income. Therefore, this offers investors more incentives to grow their real estate portfolio.
In conclusion, the main thing you need to understand is that real estate taxation is here to stay. Therefore, the only way to lighten your burden is by learning more about real estate investment taxes and deductions. Then, coming up with effective real estate investment tax strategies. And, finally, knowing how to make the most out of all the available tax loopholes.
Taking advantage of all the real estate benefits mentioned above could save you thousands of dollars every year.