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Real Estate Investing Tax Benefits: Maximize Returns While Minimizing Liabilities

By: SmallBizClub

 

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Real estate investing is a great way to diversify your portfolio and generate relatively passive income. There can be significant real estate tax benefits, as well. Although each individual situation is unique—and it’s always a good idea to speak with a tax professional if you own real estate investments—there are some common tax benefits that most real estate investors can take advantage of.

Real Estate Investment Tax Write-Offs

Operating rental properties incurs certain costs, sometimes extensive costs. Fortunately, the IRS allows you to deduct many of these expenses, including:

  • Mortgage interest
  • Property tax
  • Operating expenses
  • Depreciation
  • Repairs
  • Management expenses
  • Advertising
  • Utilities
  • Insurance
  • Materials and supplies used for maintenance
  • Expenses paid by tenant if they are deductible rental expenses
  • Home office deduction
  • Travel expenses
  • Business equipment
  • Legal and accounting expenses

This is only a partial list of the possible expenses rental owners can deduct come tax time. As you can see, there are a lot of options. Possible real estate tax deductions often depend on specific circumstances, so it’s advisable to run your deductions by an accountant before you send in your tax return.

Depreciation

Every rental property, like every investment, has an expected lifespan. The IRS considers the expected lifespan of a commercial rental property to be 39 years and a residential property to be 27.5 years. The assumption is that the asset will lose value over time, which is what depreciation refers to on your tax return. The nice thing about depreciation is that it allows you to deduct it as an expense.

To determine the basic breakdown for your depreciation tax deduction, all you need is some simple math. If your rental property is worth $500,000 and it is a commercial property, you will divide the value by 39—the lifespan of a commercial property determined by the IRS. That would be $500,000 divided by 39, which comes out to around $12,820 and change. That would mean that each year, for 39 years, you can deduct $12,820 on your tax return. That’s a significant real estate tax benefit.

You should be aware of depreciation recapture, though, in case you decide to sell the property. With recapture, you are required to pay the standard tax rate on the depreciation you have claimed so far. There are multiple ways to avoid recapture if you take advantage of other tax strategies.

Capital Gains and 1031 Exchange

When you profit from a real estate sale, you may be required to pay capital gains tax. However, whether or not you pay the tax depends on several factors. There are short-term capital gains and long-term capital gains and the IRS treats each differently.

Short-term capital gains refer to profits made from assets sold within a year of purchase. If you bought a property and sold it in the same year, you would need to pay taxes on any profits you made. The IRS looks at short-term capital gains like it does any other regular income, which means you don’t get any real estate tax benefits from such sales.

Long-term capital gains refer to profits made from sales of property purchased and then owned for more than a year. As long as you wait at least a year and a day to make the sale, your profits fall under this category. Long-term capital gains are not treated as regular income; rather, they are taxed at a lower rate than normal income. The rate varies depending on the amount of profit you earn.

A 1031 exchange allows you to avoid depreciation recapture and capital gains tax on the profits from your sale. To use this tool, you need to use your profits to purchase another investment property of equal or greater value than the one you sold.

You can use the 1031 exchange repeatedly. If you eventually decide to sell and not reinvest, you will have to pay taxes on the profits from the sale.

Self-Employment Tax

If you are self-employed, you probably know about the self-employment tax the IRS requires you to pay each year for FICA taxes. One nice thing about rental income is that you don’t have to claim it under your self-employment tax. You may have to pay other taxes on this income, but you can avoid paying self-employment taxes.

Pass-Through Deduction

As part of the Tax Cuts and Jobs Act, real estate investors operating as a sole proprietorship, LLC, S Corp, or real estate partnership have the option of deducting 20% of qualified business income from their taxes. Known as a pass-through deduction, it lets you use the deduction on your personal taxes. If you made $50,000 in rental income this year, you could deduct $10,000 from your personal taxes.

Opportunity Zones

Another aspect of the Tax Cuts and Jobs Act focused on encouraging investment in low-income or disadvantaged areas. If investors participate in a Qualified Opportunity Fund that invests in such areas to improve them, they can benefit from tax advantages depending on the circumstances. These advantages include:

  • Defer capital gains payments until 2026 or until the stake is sold.
  • Increase capital gains by 10% if the fund is held for 5 years.
  • Increase capital gains by 15% if the fund is held for 7 years.
  • Avoid all capital gains taxes if the fund is held for 10 years or more.

Remember to Keep Good Records

Taking advantage of all of these tax deductions and beneficial programs is only possible if you keep good records. The IRS may require evidence of things like your expenses to prove that what you report is accurate. If you can’t provide records, you could wind up paying all the taxes you saved and fees on top of those taxes.

The IRS recommends keeping records related to rental activities, like income and expenses, as well as receipts, canceled checks or bills, and other documentation that adheres to IRS rules and requirements.

Enjoy Real Estate Tax Benefits from Your Rental Investments

Owning rental properties can be challenging, but there are definite financial advantages, including tax benefits. Explore which deductions you can take with your accountant and keep good records to ensure you get the most out of your hard work.

woman with brown hairMegan Isola holds a Bachelor of Science in Hospitality and a minor in Business Marketing from Cal State University Chico. She enjoys going to concerts, trying new restaurants, and hanging out with friends. 

Published: April 18, 2024
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