Who doesn’t like to pay less in taxes? Taxes are by far the biggest expense we have in our lifetime, so why don’t you find every way to reduce how much you pay legally? Investing in real estate can bring with it several tax advantages and incentives to legally lower your tax bracket. We’re talking about some of them here.
How are taxes working?
Many countries , including the United States, have a progressive tax system — meaning the amount and the individual is being taxed increases gradually as their net income increases. The IRS uses a marginal tax rate to calculate your taxes on the basis of your taxable income. This is your adjusted gross income minus any qualified business costs or deductions.
There are some standard deductions for those whose main earnings come from work. But the IRS also rewards producers in our economy, so there are special tax incentives and deductions for those who own business, physical real estate, or commodities. By taking advantage of these deductions, credits and laws, you can potentially lower your tax bracket and reduce the amount of taxes you have to pay.
Change the type of income you earn
There are three different classifications of income for the IRS: earned income, investment income and passive income. The type of income you get determines how you are taxed. One of the easiest ways to reduce your tax bracket is to change how you earn your money. Earned income — also known as ordinary income — is taxed at a higher rate than investment income, and is income that you would have received from a regular W-2 job or if you were self-employed.
In real estate, the most common form of investment income is the profit from selling a property for more than the price for which it was purchased, called capital gains. Capital gains are taxed on the basis of the duration of the investment. Short-term capital gains are used for any asset held for less than one year and are taxed at a rate similar to that of earned income ( i.e. anywhere from 10% to 37%). However, if the property is held for at least one year and a day, the profit is taxed at a much lower rate of long-term capital gains tax (i.e. anywhere from 0 per cent, 15 per cent, or 20 per cent). For this reason, holding properties for at least one year before selling them is advantageous when trying to achieve the best tax rate.
Passive income in real estate is income earned through residual cash-flowing properties such as a rental, a REIT dividend, a crowdfunding income or a private equity income. Passive income is taxed at a rate similar to that of earned income, but there are deductions available to reduce the net taxable income from the investment in real estate. The largest of these is called a transient entity, which we will discuss in more detail later on.
By changing your income from ordinary income to investment income or passive income through real estate, you can lower your overall tax bracket.
Invest in S Corp or LLC properties
If you plan to invest actively in real estate — meaning that you want to spend time and effort on finding, acquiring and managing your real estate investment — there are tax advantages to creating and conducting business through a limited liability company ( LLC) or a limited partnership (LP).
What’s important is how you invest in real estate through the LLC. Rentals or properties held for longer periods of time are taxed differently from properties purchased and sold quickly — which the IRS might consider to be a dealer. If the IRS considers you to be a dealer, you may be liable to pay double the FICA taxes. FICA taxes cover social security and medical care and are typically taxed at 6.2 per cent, but if you are self-employed or classified as a dealer, you may have to pay FICA taxes twice, both as an employee and as an employer.
There are ways to avoid this by structuring an LLC so it is also an S corp. However, it is best to consult a qualified and experienced accountant who is familiar with investing in real estate to help you better determine which entity and structure would be best for you.
The benefits of the LLC go beyond tax incentives. They are commonly used in real estate because they can potentially reduce liability and, if properly set up, offer a certain level of protection in the event of litigation. Oftentimes, real estate professionals will have several different pass-through entities primarily for tax and asset protection purposes.
Use the 20% pass-through deduction
The Tax Cuts and Jobs Act (TCJA) of 2017 created a new deduction for businesses that operate as a pass-through entity, such as an LLC, S corp, or limited partnership. Pass-through deduction, also referred to as section 199A, allows taxpayers who earn less than $157,500 for single filers or $315,000 for joint filers to deduct 20% of their qualified business income (QBI) that they receive through their pass-through business.
This allows some small business owners or self-employed individuals to pass the business deduction to their personal tax return. This lowers business taxes while deducting up to 20% of the net income from personal taxes. While this deduction is not exclusive to real estate, it applies to anyone who purchases and owns real estate through an entity. For example, the landlord owns and manages a number of rental properties in the LLC, which earned a net income of $30,000 from expenses and deductions. The landlord can potentially pass $6,000, or 20 percent of the net income from the pass through entity as a deduction on their personal taxes.
Pass-through deduction shall not apply to corporations, employees’ income or service professionals such as dentists or physicians. But it is available to those who earn income through:
- Rent property and spend at least 250 hours a year or more managing the rental.
- Originating or investing in mortgage notes and spending at least 250 hours managing the asset
- Dividend payments from shares in a REIT
The 20% deduction can be an incredible tool for individuals who invest in real estate to reduce their tax bracket. If you think you could benefit from this tax incentive, talk to a local and qualified tax professional about your business to see if you would qualify.
Take advantage of real estate business deductions
One of the easiest ways to lower your tax bracket through real estate is by making the most of the deductions available to business owners. There are a number of deductions specific to business owners and real estate investors, such as:
- Property taxes and insurance paid on an investment property (which can not be deducted on a personal residence)
- Mortgage interest (which may be deducted for both a personal residence and an investment property)
- Fees for property management
- Property repairs, including capital improvement
- Advertising expenditure
- Legal and professional fees (such as accountants or accountants)
- Office expenses, including home office expenses
- Travel and mileage expenses
- Education and membership (such as the annual fee for a trade association or the cost of a seminar, book or course on a subject related to your industry)
- Meals (entertainment, such as taking a client or a private lender to a baseball game, is no longer deductible by the TCJA)
Utilizing these deductions when investing in real estate can potentially add up to a notable decrease in your tax bracket.
Deducting passive losses
Although no one buys an investment in real estate with the intention of losing money, investment in real estate carries risks and losses in real estate are not unusual. Additionally, what may be positive cash-flowing assets can appear as a loss on your tax return after depreciation and tax deductions have been applied.
Passive investments, such as rental properties, can lead to passive losses. Passive losses can only offset passive income — so you can write off as much loss as you have in passive income. For example , if you make less than $100,000 a year and three of your six rental properties have a passive loss of $10,000, you can only write off $10,000 if you also have $10,000 or more in passive income from your other three rentals. If you don’t get $10,000 in passive income from the other three, you can not deduct the full $10,000 that you incurred in losses.
With the rental loss allowance, if your adjusted gross income (AGI) is less than $100,000, you may be able to deduct up to $25,000 in passive losses across all leases.
Situations where the investor does not have enough passive income to compensate for passive losses are fairly common and losses can be carried forward to future tax years. However, those who meet the requirements of real estate professionals may treat passive income losses as active. So let’s look at how you can qualify as a real estate professional.
Gain a professional real estate designation
A real estate professional designation offers a significant tax break that can significantly reduce your taxes. With this designation, you can deduct up to 100% of your rental losses from any other type of income, including ordinary income. If you have $10,000 in passive losses, you no longer need $10,000 in passive income to compensate for that. You can deduct the entire $10,000 against any other income, including other real estate income or possibly self-employed income.
To qualify, you must devote a minimum of 750 hours per year to and actively participate in your real estate business. At least 50% or more of your time needs to be spent actively working on the rental, including management or services. Actively participating may include meetings with contractors, tenants, on-site managers or lawyers, in addition to reviewing or drawing up contracts, leases, marketing campaigns or offering memoranda.
The goal is to have most of the work you do in an active role rather than a more passive one, such as reviewing your accounting, financials, or learning more about your business. Keep in mind—750 hours is the minimum threshold to qualify. If you are audited and the IRS disqualifies you for a few hours, you may lose the designation and any deductions received from that designation. It ‘s ideal to have around 900 hours or more dedicated to that business, as well as proven records showing your active role in at least one half of the services or management performed for each investment property.
Although there are advantageous tax incentives to be appointed as a real estate professional in the eyes of the IRS, active management, dedication of a significant amount of time and you need to be qualified. If your goal when investing in real estate is to do so as passively as possible, this designation and its tax incentives will likely not be an option.
Depreciate your property
Depreciation is a deduction available to property owners that allows them to take a small deduction each year to account for the average wear and tear on an asset over time. Residential properties may be depreciated over a period of 27.5 years. Commercial properties may be depreciated over a period of 39 years. If you purchased a residential rental property for $200,000 you would be able to depreciate or deduct $7,272 each year on your taxes ($200,000/27.5).
Although the depreciation now offers a deduction in taxes, the deduction is recovered from the sale of the property. So, if you sell the property, any depreciation taken at that point would be recovered. However, there are tax-deferral strategies, such as an exchange rate of 1031, which could potentially prevent or delay the recovery of depreciation.
Cost separation is the process of identifying the different components of the property for depreciation purposes. Instead of depreciating the entire asset at the same time , cost separation depreciates different aspects of the property over different periods of time.
Bonus depreciation and cost separation
For example, you can cost-segregate the land the property is on, as well as the building itself and any construction or capital improvements that were made to the property. Cost separation may increase the amount of depreciation due to the accelerated period of time during which certain parts of the asset can be depreciated.
Bonus depreciation is a temporary change to our tax legislation that allows taxpayers to potentially deduct up to 100% of certain qualifying assets associated with a qualified investment property. This means that investors can now accelerate the time when items such as a new roof, light fixtures, interior paint, new flooring or appliances can be depreciated from five, seven, or 15 years to potentially 100% in the first year.
For example , if a new roof was installed on a commercial property that cost $35,000 this entire cost can be depreciated in the year it was completed, rather than having to depreciate it over a period of five to seven years. This converts a deduction of $5,000 in depreciation per tax year into a one-time deduction of $35,000.
According to the IRS, improvements do not qualify if they are attributable to:
- The enlargement of the building
- Any elevator or climber
- Internal structural framework for the building
With section 179 of the tax law, commercial real estate can now cancel the installation of HVAC, fire protection systems, alarm systems and security systems, as well as landscaping. In the past, you couldn’t write them off because they were part of the building. But the new tax legislation means that you can do it now.
In order to qualify for bonus depreciation, the property must have been acquired after September 27, 2017, and before January 1, 2023, and the depreciation of the bonus must be taken in the year in which the qualifying property was purchased. Keep in mind that, when taking advantage of bonus depreciation, the asset will have fewer depreciation deductions in the following year. The tax law rewards those who continue to invest, so it is ideal to continue to purchase new properties each year in order to take advantage of the tax deduction on depreciation bonuses.
Find an experienced accountant to help you
Be proactive in planning your taxes. What you do on a daily basis affects how you earn income, how much tax you pay, and how quickly your financial goals are achieved. Most people consult their accountants after they have made a big decision that could affect their tax bracket.
Instead of taking a “as needed” approach to tax planning, learn about tax law and what behaviors, investments, and spending patterns tax law rewards. That way , you can make more informed choices by investing in real estate. Tax laws are changing, and it’s important to have a high-quality accountant who can help you navigate the various deductions available and hopefully help lower your tax bracket through your real estate investment.
The “Unfair Advantages” of Real Estate just got a lot better.
Investing in real estate has always been one of the most effective ways to achieve financial independence. It’s because it offers incredible returns and even more incredible tax breaks.