- Capital Gains
- 1031 Exchange
- Tax-Deferred Retirement Plans
- Self-Employment/FICA Tax
- Opportunity Zones
What are the perfect real estate investment tax deductions?
Real estate continues to be one of the most common investing approaches to preserve and maximize one’s income. In tandem with the opportunity to produce cash income, buying in real estate often opens up a pool with tax benefits that renting does not do. In reality, Uncle Sam can become the best friend of the investor, because there is a massive amount of real estate investment tax benefits available. The trick, however, is to understand what is available and how to capitalize on it.
Navigating the Best Real Estate Investing Tax Gains
Among the favored investing alternatives, real estate provides large tax incentives on everything from leasing properties, apartments, vacant land, commercial and industrial buildings, and shopping facilities. For investors, possession of property may bring significant tax savings, such as tax sheltering.
While real estate does provide a small number of tax advantages to investors, these tax breaks could be overwhelming for a lot of people. Here we will break down the very best real estate investing tax advantages, including a few of the best write-offs and deductions for property investors:
- Passive Income & Pass-Through Deductions
- Capital Profits
- 1031 Exchange
- Tax-Deferred Retirement Accounts
- Self-Employment/FICA Tax
- Opportunity Zones
One of the main real estate tax incentives provided to owners is in the form of deductions. These tax write-offs, which are usually targeted towards rented homes, may cover the costs of mortgage interest, income tax, running expenses, depreciation and maintenance. Let’s explain:
As a property manager, you can subtract the ordinary and necessary costs of handling, storing and sustaining the land. This business expenses may typically entail mortgage interest, property taxes, ads, repairs, energy and insurance. Since improvements maintain the house in good shape and do not add value to the land, owners will write off improvements. Examples involve repairing leaks, painting and restoring damaged parts of the rental house.
Investors can also subtract their mortgage interest from their primary — and sometimes secondary — residence. This exclusion refers to house sales or recently refinanced mortgages, home equity credit lines and home equity loans.
Tip: It is necessary for investors to carefully itemize the deductions. For investors starting a business, deductions may also come in the form of non-real estate transactions, such as the use of your home office. In many cases, investors will be able to deduct a percentage of their home labor costs, such as the Internet and telecommunications bills.
Passive Income & Pass-Through Deductions
Passive income in regards of real estate is any money that is received from business activities that investors do not actively engage in. Most of the time, it’s rental income. The Tax Cuts and Job Act, which was enacted in 2018, requires profitable companies that earn eligible business income (QBI) to make use of a pass-through deduction. This helps taxpayers to exclude up to 20% of their net business income, thereby lowering their effective income tax rate by 20%. It is currently available until the year 2025.
Capital gains are money earned by homeowners as they sell their real estate, which includes housing, private, commercial or industrial properties. Generally, they are taxed in one of two ways: 1. Short-term capital gains; 2. Long-term capital gains.
- Short-term: This refers to investment property earnings that have been kept for one year or less. Although there is no preferential tax status for short-term capital gains, investors would continue to pay taxes on a standard IRS-defined tax bracket.
- Long-Term: These capital gains are made from property that has been owned for more than one year and is usually related to rental properties. Capital long-term returns are much more beneficial to taxpayers because their tax rate is lower than short-term gains.
Tip: As an investor, long-term capital gains are the path to pick. You are going to be taxed much less and you can use prior deductions to lower the taxable amount. In fact, taxpayers need to learn about the deduction of capital gains, which is probably the largest of all the tax benefits. This can be used more than once to encourage homeowners to be exempt from paying taxes on income of up to $500,000 from selling their house. In the worst case scenario, if capital losses outweigh capital gains, investors will be able to make up more than $3,000 of additional income. For them, it’s a win-win.
Another massive tax break that applies to rental properties is depreciation. In essence, this involves recovering the cost of the income-producing property through annual tax deductions. According to the IRS, the depreciation allowance is defined as an allowance for exhaustion or wear and tear, and there are three factors that determine how much depreciation an investor can deduct each year. They include:
- Their base in the property (how much is the value of the property?)
- The recovery period for the property
- The depreciation method used.
Investors typically use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS). The IRS allows investors to deduct depreciation on residential property for 27.5 years and on commercial property for 39 years. Depreciation is defined as a net loss on an investment property, even if the asset provides a positive cash flow.
Tip: Since investors already deduct the cost of their rental property, the depreciation exclusion gives investors a creative way to save money on an annual basis.
Named for Section 1031 of the Internal Revenue Code, 1030 Exchange is a swap of one investment property for another. Although most stock swaps are taxable as transactions, 1031 Exchanges would have no tax — or minimal tax — at the time of trade. To investors, that ensures that you will roll over profits from one piece of real estate property to another, avoiding taxes before you finally sell it a year later.
In order to effectively achieve a 1031 exchange, investment assets must satisfy the following criteria:
- The value of the substitution property must be equal to — or greater than — the value of the resigned property.
- Assets in the deal must be traded for some kind of collateral, such as the Real Estate Investment Trust (REIT).
- The traded land must be kept for “economic purposes in the context of business or trade.”
Tax-Deferred Retirement Accounts
Certain health savings accounts (HSA) and individual retirement accounts (IRA) give creditors the ability to buy tax-deferred real estate (meaning they can actually invest in real estate and pay tax on it later). Certain accounts have annual contribution limits as well as restrictions on the types of investment that can be made, so be sure to do your research in advance.
As a real estate investor, this tax benefit will save you on the income you receive from the rental property. FICA, which stands for the Federal Insurance Contributions Act, is a 15.3 percent levy and is split 50/50 between the employer and the employee. As a self-employed company owner, you are responsible for a complete 15.3 percent levy. However, depending on how you lawfully arrange your real estate business, this can be balanced.
Opportunity zone funds were launched as a tax incentive in 2018 as part of the Tax Cuts and Jobs Act to encourage growth in more than 8700 opportunity zones across the US. To be clear, the opportunity zones are some of the most impoverished and rural areas in the country. Investors may transfer the capital gains they earned from selling investment property to an opportunity zone fund, allowing them to defer or pay no capital gains tax on their original investment. With a new system, the rules and specifications are often changed, so make sure to search for any potential new info.
Two of the biggest advantages of investing in real estate are the tax breaks that are open, but others are ignorant of these incentives and how to take advantage of them. Learning through real estate tax investment incentives are at the fingertips is one of the key ways that real estate investors can gain long-term prosperity. Taking advantage of these tax breaks to insure that you continue on the road of financial freedom while shielding yourself from avoidable costs.