Top 6 tax advantages of real estate investment
The major tax benefits to be gained from real estate investing include, but are not limited to, the following.
1. Deductible expenses
Many common expenses incurred by real estate investors are considered deductible expenses that can be claimed on your taxes. This means you won’t have to worry about paying government-imposed taxes on these expenses.
In fact, some aspiring real estate investors are even using the home hacking process to compound deductible benefits, as homeowners can gain access to additional tax deductions when investing in their primary residence. Here are some of the many common tax-deductible expenses you can potentially leverage in real estate investing depending on your ownership and business relationships:
If you have questions about expenses that may be tax deductible, consult a qualified tax professional. You might be surprised at the amount of money you might be able to deduct.
The practice of depreciation helps account for the wear and tear that occurs on a property over time. In effect, it provides a way to help real estate investors benefit from tax deductions on rental properties, which inevitably suffer the negative effects of use over a long period of years.
Depreciation is determined by calculating the useful period (i.e. useful life) of the property and applying a formula to calculate the value lost each year. Once done, you can claim the annual deduction on your taxes, which can help reduce your taxable income.
To calculate property depreciation, start by determining your cost base in the property, dividing it by the useful life of the property, and calculating a depreciation schedule. Once this scale has been calculated, you can use it to calculate and secure the annual tax deductions.
When selling your property, be aware of a practice known as recaptured depreciation. Essentially, when you apply depreciation to a property, it lowers your cost base in the investment portfolio. At the time you sell the property, the IRS will calculate the capital gains tax based on a profit margin that reflects this new cost basis – an example of recapturing depreciation at work.
Say you buy a new property for $250,000 and then apply depreciation of $50,000, which would reduce your cost base to $200,000. If you were to then sell the property for $300,000 at a later date, the IRS would calculate your capital gains tax using a profit margin of $100,000 instead of $50,000.
3. Passive income and transfer deduction
Under the terms of the Tax Cuts and Jobs Act 2017, a helpful tax deduction has been created for property investors, small business owners and self-employed professionals. This deduction is known as the qualified business income (QBI) deduction, or transfer tax deduction in common parlance.
According to the QBI, eligible parties may receive up to 20% deduction on income received from pass-through business entities such as partnerships, sole proprietorships, S corporations and limited liability companies (LLCs), such as on qualified rental income. Real estate income received this way is often classified by the Internal Revenue Service (IRS) as passive income, although it may take considerable work to bring in tenants and rents on a recurring basis.
As such, you may qualify for other tax savings benefits and deductions depending on the type of property you own and how it operates.
4. Capital gains tax
If you’re currently involved in, or thinking about diving into, the world of real estate investing, you’ve no doubt heard of capital gains tax. Essentially, every time you sell an asset that appreciates in value, you may have to pay taxes on the profits made on that investment – single family homes, multi-family residences, apartment/condo buildings and other included properties.
Capital gains tax generally applies to the appreciation of your investments, but can also vary depending on your income, how long you own the asset and your tax status.
For example, if your taxable income is below certain current thresholds, capital gains tax may vary from 0% to 15%, or increase to 20% if your taxable income exceeds these thresholds. It also depends on how long you have held the assets. Here is a breakdown of the difference between short and long term capital gains.
Short term capital gains
Short-term capital gains are profits you have made on assets you have held in your investment portfolio for 12 months or less. These capital gains can have a negative impact on your taxes because they are treated as general income and taxed at your marginal tax rate (ie your current tax bracket). If a year passes before you sell the asset and recognize those gains, any profit would instead be considered a long-term capital gain.
Long-term capital gains
Long-term capital gains are earnings seen on assets you’ve owned for at least a year. Income earned in the form of long-term capital gains is taxed at a lower tax rate than income earned from short-term capital gains, typically being charged at a rate of 15-20% over marginal tax rates. If you can, it’s usually beneficial to hold on to your investments a little longer with these savings opportunities.
5. Incentive programs
Real estate investors, depending on how they structure their property and property portfolio, may also be eligible to take advantage of various tax incentive programs. These incentive programs allow you to recognize additional tax savings on qualifying investments and income, while limiting eligibility accordingly.
The 1031 exchange allows you to sell one business or investment property and buy another without incurring capital gains tax. However, the exchange must be properly made and done according to IRS rules. Your new property must be of the same nature as the original, and of equal or greater value to the property sold.
A 1031 exchange effectively allows you to exchange one real estate investment in place of another and defer taxes on capital gains. Note that using a 1031 exchange only allows you to defer payment to a later date – not reduce your tax bill or avoid paying taxes entirely.
Created through the Tax Cuts and Jobs Act 2017, Opportunity Zones are a way for the government to encourage individuals and businesses to invest in certain communities to promote economic growth.
These geographic regions have been identified as low-income census areas and targeted for job growth and economic stimulation. Real estate investors can capitalize on opportunity zones by transferring qualified capital gains into an opportunity zone fund within 180 days of selling an asset.
Tax-free or tax-deferred retirement accounts
Some tax-exempt and tax-deferred retirement accounts (for example, some 401(k) plans and Roth IRAs) may offer you opportunities to invest in alternative assets beyond stocks and bonds. These opportunities may include private or commercial real estate, real estate investment trusts (REITs) and other real estate holdings.
However, tax-deferred and tax-free retirement accounts often come with savings contribution limits and requirements that vary by account. Before you apply, you’ll want to consult with a qualified financial professional to determine how much, if any, these accounts can help you reduce your tax burden.
6. FICA self-employment tax
Under the Federal Insurance Contributions Act (FICA), the self-employed are responsible for 15.3% of Social Security and Medicare income taxes. However, while rental income is taxable to some extent under standard income guidelines, it is not subject to FICA taxes.
Filing a Schedule E tax form lets the IRS know how much rental income you earned and how taxes should be applied here. Although Schedule E income is generally not subject to self-employment tax, certain types of rental activities may trigger self-employment taxes, making it important to be aware of this as as a real estate investor.