What are the best investment property tax benefits?
Investing in property continues to be a top choice for safeguarding and increasing individual wealth. Along with the reward of making money by doing so, buying real estate also provides a variety of tax benefits unavailable to tenants. The federal government, through Uncle Sam, could be a helpful ally to individuals who want to invest in property, with a plethora of tax advantages being offered. Figuring out what is accessible and learning how to take advantage of it is the key element.
Don’t forget to check out our other post in this series, 6 great tax benefits of investing in real estate.
Navigating The Top Investment Property Tax Benefits
Real estate is an attractive option for investing, with major tax benefits for investments such as rental properties, apartments, vacant land, industrial and commercial buildings, and shopping centers. For investors, real estate ownership can bring about considerable tax reductions, as well as providing tax advantages.
Real estate investment can come with some tax advantages, but they can be too much to handle for some people. Here we’ll break down the top real estate investing tax benefits, including some of the top write-offs and deductions for real estate investors:
- Passive Income & Pass-Through Deductions
- Capital Gains
- 1031 Exchange
- Tax-Deferred Retirement Accounts
- Self-Employment/FICA Tax
- Opportunity Zones
Real Estate Deductions
Real estate investors can take advantage of numerous tax deductions when they own a property. These deductions can be substantial, helping to reduce their tax bill and improve their profits. This text is about various deductions for rental properties that permit the owner to submit diversified costs connected to the maintenance, loan expenses, and operating costs of an investment building.
The Internal Revenue Service (IRS) regards buying real estate as an investment with the view of making money as a business deal. Thus, any costs associated with this buy are accepted as valid business expenses that can be claimed for tax deductions. These include:
- Mortgage interest: The interest portion of your monthly mortgage payment is tax deductible.
- Property taxes: These can be written off as a cost of owning the property.
- Property insurance: Like property taxes, property insurance is a tax write-off for investment properties.
- Ongoing property maintenance/repairs: Any money that you spend to repair damages or maintain the property can be deducted. If you’re upgrading a property, however, that is not a tax write-off.
- Contractors/equipment: Contractors or equipment hired for maintenance or repair.
- Property management fees: If you hire a property management company, that is considered a tax-deductible expense.
If you’re investing in real estate through limited liability partnerships or limited liability companies, you can also use the following real estate business deductions available to business owners to lower your tax bill:
- Office space
- Business equipment
- Travel and mileage
- Advertising expenses
- Legal and accounting fees
Passive Income and Pass-Through Deductions
Passive income generated through real estate investing is money that is attained without physically engaging in the business activity. The most widespread source of income that is received without being actively worked for is rental profits obtained from an estate asset. No tax deductions were available for this income prior to 2018, however, that was altered by the introduction of the Tax Cuts and Jobs Act of 2017.
The Tax Cuts and Jobs Act enables businesses who make qualified business income (QBI) to take a deduction of up to 20 percent of their taxable income, including rental income, thus decreasing their effective income tax rate by 20 percent. This tax break has an end date of 2025 and will only be viable if your business makes money in the fiscal period of your tax return.
Investments through Real Estate Investment Trusts (REITs) – as is the case for all of the investments made by Arrived – are eligible for pass-through taxation.
The profit you receive when you sell a property for a higher price than you originally paid for it is referred to as a capital gain. This involves all sorts of real estate, including homes, businesses, and investing in rental properties. Taxes on profits made from the sale of assets are generally lower than the same taxes applicable on other forms of income, making real estate investment a beneficial option from a tax standpoint. Capital gains are taxed in one of two ways:
Short-Term Capital Gains
These are gains that come from investment properties that were kept for a period of less than twelve months. Short-term capital gains are not given any preferential tax treatment and thus, the same tax rate that applies to standard income will be implemented.
Long-Term Capital Gains
Profits from investments kept for over twelve months are known as long-term capital gains. Gains on investments held for a long time are subjected to a lesser rate of taxation than usual earnings, varying between 0%, 15%, and 20% depending on the amount of your earnings. Investing in real estate for the long-term can be highly lucrative due to the reduced tax imposed on long-term capital gains.
For investors, generating long-term capital gains is the optimal approach. You will be relieved from considerable taxation, and you can make use of any applicable deductions for reducing the sum of money liable for taxation.
According to Steve Scott, CTO at Spreadsheet Planet, from an investment perspective, it is beneficial to keep income properties for the long term since the profits that are earned from the sale will be assessed at 0%, 15%, or 20%, based on the person’s income bracket. If you engage in activities such as flipping or wholesaling with a short-term outlook, you will not receive any special tax benefits, since any profits you earn will be taxed as higher-rate short-term capital gains.
In addition, investors should be aware of the capital gains exemption, which is likely the most noteworthy of all the tax advantages of investing in property. This measure can be utilized multiple times to exempt homeowners from shelling out taxes on up to $500,000 of revenue they make from selling their homes. Under the most unfavourable conditions, if capital losses are greater than capital gains, investors can subtract up to $3,000 of other earnings from their tax bill. It’s a win-win for investors.
Depreciation is a gradual dwindling of an asset’s worth caused by normal usage. Each year, the Internal Revenue Service permits a depreciation allowance on profit-generating properties depending on the worth of the asset, the timeframe for recuperating it, and the technique employed for depreciating it.
The Modified Accelerated Cost Recovery System (MACRS) is the most frequently applied technique for determining depreciation. This system grants the power to subtract depreciation from any rental residence over a span of 27.5 years – the “useful life” of a house – as well as 39 years for a commercial real estate property.
Depreciation on an investment property is categorized as an net decrease, regardless if the actual estate investment is creating a positive cash flow. The depreciation deduction is of extreme worth to those investing in realty, as one can make this deduction without paying money for the cost. If you fork out any money for repairs, maintenance, and upkeep of your property, it will be separate from the other costs associated with your home. No homeowners who reside on the premises are eligible for this deduction.
It is essential to bear in mind that even though a real estate’s “useful life” is seen as 27.5 years by the IRS, properties can endure much longer, resulting in investors gaining a higher return in the initial years of investing.
Real estate speculators can exploit a provision in the Internal Revenue Code known as 1031 Exchange to delay the taxes on an investment property if the proceeds from the sale are used to buy another.
As an investor in real estate, it is necessary to pay taxes on the gains realized when a property is sold with a profit made. The 1031 Exchange tax code enables the deferment of capital gains tax that you would ordinarily need to pay when capital from a sale of real estate is reinvested in another real estate purchase. So long as the funds are kept in real estate, no taxes are levied.
A few things to remember about 1031 Exchanges:
- The replacement property must be of equal or greater value than that of the property sold.
- You must identify the new property you plan to buy within 45 days and close on that property within 180 days.
- The property transactions must be similar in nature. For instance, a property cannot be exchanged for other types of assets, such as Real Estate Investment Trusts (REIT).
- The exchanged properties should be used for “productive purpose in business,” that is, as an investment, and not as a residential property.
The 2017 Tax Cuts and Jobs Act gave rise to opportunity zones, an effort to stimulate financial prosperity in the most troubled and downtrodden parts of the United States. The Internal Revenue Service (IRS) has eight thousand, seven hundred and sixty four areas eligible for meaningful tax deductions when investors put their money into them. These areas span across all fifty states of America.
Investors who sell an investment property have the option to use the proceeds from the sale and place them into an opportunity zone fund, allowing them to either delay capital gains taxes or avoid them altogether on the original investment.
The tax benefits of investing in an opportunity zone include:
- Temporarily defer taxes: You don’t owe any capital gains until 2026, or until the asset is sold.
- Grow capital gains by 10%: If you place capital gains in an opportunity fund for at least 5 years, the basis on the original investment will increase by 10%. After 7 years, the basis will increase to 15%.
- No capital gains: If you remain invested in the fund for 10 years or more, you can forego paying capital gains entirely and have it be tax-free profit.
Tax-Deferred Retirement Accounts
HSAs and IRAs give investors a chance to make investments in real estate without having to pay tax on it in the present moment. They will be obligated to pay taxation on their land holdings at a deferred date. It’s important to be informed beforehand, as some accounts have restrictions on how much money you can put in annually, as well as what kind of investments are available. Conduct thorough research for the best results.
As a real estate investor, this income tax advantage will provide a financial advantage when dealing with revenue generated by your rental properties. The Federal Insurance Contributions Act (FICA) is a tax requiring both the employer and the employee to contribute 15.3%, with each paying 50% of the total levy. As the proprietor of a self-run organization, you are in charge of paying the whole 15.3 percent tax. Regardless of how you organize your real estate venture, you may be able to reduce your liability.
There is a bit more nuance to this as you need to qualify as a real estate professional in order to take full advantage of this through real estate, but at least know that it’s out there for you to learn more about.
As the tax season approaches, you can make the most out of your real estate investment deductions if you keep precise documentation. To organize your records for investment property tax benefits, you should:
- Keep all your receipts.
- Organize what you spent on your property.
- Track all potentially deductible business expenses.
- Prepare and maintain financial statements.
- Sort the types of investments you made on your property.
If you stay on top of your paperwork and filing, you’ll have a simpler time doing your taxes and it will be advantageous to your financial position. Your accountant will be grateful and you can dodge any possible issues with the Internal Revenue Service by keeping your financial documents up-to-date.
Investment Property Tax Benefits Example
Let’s examine an example to demonstrate the advantages of investing in real estate and the tax advantages that may be available.
It could be stated that you make an investment of $400,000 for a revenue-producing property. You put down 20 percent, which is $80,000. The property results in a total of $10,000 in net earnings each year (lease proceeds of $30,000 minus $20,000 in expenditures, counting mortgage payments). Through the depreciation reduction allowance, a further $14,544 (3.646%) may be subtracted – leaving a shortfall of $4,544. This implies that you received the amount of $10,000 from passive income in the initial year, but you didn’t need to pay any taxes for it due to the fact that you were reporting a net deficit.
This is just one example of tax savings. You can also make use of a write-off to lower your overall personal net income by 20%. You can take advantage of a 1031 exchange when selling your property in order to realize a gain. You are able to transfer any gains on the sale of a property to invest in a newer one which generates a greater return, therefore disregarding the recapture of declines in value.
To conclude, you could find yourself in a beneficial situation where you make passive income but pay either minimal or no taxes on it. Furthermore, you can utilize your earnings to boost your investments without having to incur taxes on any profits.
Purchasing An Investment Property For Tax Purposes
It is undeniable that owning real estate carries with it some tax advantages. There is a thought that gets mentioned frequently regarding whether or not investors should buy real estate to take advantage of its advantages. In the end, owning rental real estate can provide advantages in terms of property tax deductions and other advantages. If your goal is simply to get deductions or balance out other investments, it’s likely not a good idea to purchase an investment property for the tax benefits. Investing in real estate involves many factors, and failure is likely to occur if a property is acquired without being knowledgeable of the market and loan options.
If you desire to pick an approach with some tax advantages as you make an investment, real estate may be a choice to look into. There are multiple aspects to a real estate deal. Before investing in real estate, review the basics of the subject and determine if the venture is the right fit for your financial objectives.
One of the major advantages of investing in property is the potential to receive numerous tax deductions. Many lack knowledge of the available opportunities and how to utilize them effectively. Knowing about the tax benefits accessible to real estate investors is an effective way to gain long-term wealth. Benefit from these tax exemptions and guarantee that you will stay on the route to monetary self-determination while shielding yourself from superfluous charges.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor, media buyer, faithful Red Sox Fan.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here, or get a hold of him on Facebook or Twitter.