Steve Byrne is foathe of EquiSource and has been in commercial real estate investment, management, and finance for nearly 40 years.
Real estate investing can provide for significant tax benefits, but the trick – and often the tallest hurdle – is identifying the available strategies and understanding how and when to use them.
These opportunities are neither obvious nor transparent and can often require lengthy research. The results, however, can be well worth the effort. Taking full advantage of these tax benefits can help you build significant long-term wealth by mitigating – or avoiding altogether – certain tax obligations.
Is Investing In Real Estate Tax Deductible?
Yes, earning tax deductions is a primary and powerful benefit of real estate investment. For rental properties, these deductions can include (but are not limited to):
• Mortgage interest payments
• Property taxes
• Ongoing property maintenance
• Property insurance
• Independent contractors
Real estate investors can take further advantage of available tax benefits by investing in real estate through limited partnerships and limited liability companies. These structures provide for additional business-related deductions, such as:
• Professional fees
• Office space
• Travel and mileage expenses
• Real estate software tools
• Advertising expenses
Five Primary Real Estate Investment Strategies For Tax Advantages
The tax code provides for several real estate tax strategies for minimizing tax liabilities or generating refunds. Some of these concepts are well-established and time-tested, while others are relatively recent additions. Five of these strategies are as follows:
Depreciation is the recovery of costs to maintain investment properties through annual tax deductions. Over time, the real estate will begin breaking down, and the depreciation deduction is in essence a recompense for the “wear and tear” of the property. For tax purposes, depreciation is always considered a net loss on the real estate investment independent of any profits realized on the property.
The allowed deduction amount is determined by the property’s market value, the property’s recovery period and the depreciation method used. The most commonly used depreciation method is called the modified accelerated cost recovery system, which allows investors to deduct depreciation on a residential property and commercial real estate for 27.5 years and 39 years, respectively.
2. Self-Employment/FICA Tax
Social security and Medicare income taxes of 15.3% are split evenly between you and your employer. However, if you have no employer because you are self-employed, you are responsible for the entire 15.3%.
While rental income is taxable as standard income tax, it is not subject to these FICA taxes. Even if you are self-employed, any income relating to a rental property is immune to both the social security and Medicare taxes you would otherwise pay on either a 1099 or W-2.
3. Opportunity Zone Funds
The Tax Cuts and Job Act of 2017 includes a tax incentive for investing in the country’s most rural and financially distressed areas. The act designates nearly 9,000 of these areas as Opportunity Zones, in which investors can put the capital gains earned from selling other investment properties as a means to defer capital gains tax on their original investment.
4. 1031 Exchange
A 1031 Exchange is the exchange of one real estate investment property for another similar property. A qualifying exchange will have either zero or minimal tax liabilities, unlike most asset swaps that are taxable at the point of sale.
This means you can roll over capital gains from one real estate investment to another, avoiding taxes until you sell the property – so long as you hold the asset for at least one year. In other words, capital gains taxes are only paid upon a final sale of a property that includes no exchange.
To qualify as a 1031 Exchange, the two properties must meet these requirements: The properties must be exchanged for a tangible asset. The new property’s value must be greater than or equal to that of the exchanged property. The property must be held for business purposes.
5. Passive Income And The Pass-Through Deduction
As it relates to real estate investments, passive income is any money that is earned from rental-related business activities in which the investor does not actively participate. Historically, this income has not been eligible for pass-through tax benefits.
The Tax Cuts and Jobs Act of 2017 established a new pass-through tax deduction for rental property owners. Owners may be able to deduct up to 20% of the net rental income received, or 5% of the original cost of the property plus 25% of employee payroll expenses.
This deduction, established in 2018, is related specifically to income tax and is unrelated to rental deductions. This special income deduction is scheduled to expire in 2025.
Your Tax Benefits From Real Estate Investing Can Impact Future Decisions
Knowing these real estate investment tax strategies is important not only for squeezing out all possible deductions but for making investment decisions as well. A comprehensive understanding of where your deductions are coming from, how they will be applied and the amounts to be expected can all help influence future strategies, whether they are personal or business in nature.
Maximizing your tax benefits requires recording and maintaining as much information on your property as is possible. Document all improvements, renovations and associated expenses. Keep track of the property’s estimated market value.
While retaining a knowledgeable CPA is recommended and will help alleviate the stress, having a general understanding of these strategies and a thorough record of your real estate investment-related expenses will aid in those conversations, minimize your CPA costs and make your tax filing much easier.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.