Tax incentives are a big reason to become a real estate investor. From a multitude of potential deductions for rental property owners, depreciation, pass-through income, and utilizing capital gains taxes instead of income taxes.
There are plenty of perks from Uncle Sam waiting for the real estate investor. Naturally, we suggest consulting a tax professional who has experience working specifically with real estate investors to find out how you can maximize your tax benefits.
When it comes to tax benefits for real estate investors, we tend to think in terms of filing year-end taxes and getting a break on tax liability. But this isn’t the only way that real estate investors can score extra benefits.
Tax deferral strategies are a big part of investing in real estate — don’t overlook them!
2 Methods of Tax Deferral for Real Estate Investors
The 1031 Exchange
The 1031 exchange has long been considered one of the best tax-deferral strategies for real estate investors. For our part, we know that we have helped dozens upon dozens of passive investors navigate this process.
To keep it simple, a 1031 exchange is a process in which an investor performs a “like-kind” exchange. In other words, if you meet the criteria for a 1031 exchange, you will be able to “swap” one investment property for another without incurring capital gains taxes. You will only pay capital gains taxes if you sell the property for cash down the road and incur capital gains.
That said, there are indeed criteria to meet and opportunities to owe capital gains taxes anyway. If you, for example, are owed money by the owner you’re swapping properties with, that will be taxable income. Similarly, a reduction of liability (say, due to mortgage changes) can also be seen as income by Uncle Sam. Thus, you’d owe taxes.
Not only that, but investors have to find a like-kind property for the exchange within a 45-day window. There are also requirements such as having a QI (qualified intermediary) to hold funds throughout the exchange. You can’t touch the money associated with it without incurring a tax liability.
A lot is going on here. It’s a great strategy, but full of nuance and unique considerations. That’s why we’ve written a handy guide for investors:
Keep in mind, too, that our advisors are no strangers to 1031 exchanges. We know how to get the job done for our investors. Having our experience to lean on is a great advantage for investors at every level.
With all that said, there have been various pushes over the years to end like-kind exchanges such as the 1031 exchange, even as recently as 2020. This causes worry among investors, but it doesn’t spell the end of tax-deferral strategies.
The Self-Directed IRA (SDIRA)
Even if the 1031 exchange ends as a tax-deferral option for real estate investors, there are other ways to invest tax-free (or tax-deferred). One option is to invest through a self-directed IRA (or SDIRA). Traditionally, IRAs do not allow one to choose investments outside of stocks, bonds, and mutual funds. Rather, an SDIRA owner can invest in other options — real estate included.
This is notable because, as in both an IRA and an SDIRA, contributions to the account are tax-deductible. Furthermore, transactions within the account are tax-free. Your tax liability only incurs once you decide to withdraw funds from the account.
For real estate investors, this creates a unique opportunity to build and diversify a real estate portfolio within an SDIRA, which is highly advantageous to one’s tax standing.
Of course, as with the 1031 exchange, there are many governing rules and regulations, including disqualified persons and provisions against self-dealing. Every investor must follow appropriate IRS regulations or face the consequences.
Unlike the 1031 exchange, there’s never been a threat of ending the IRA account or its various iterations. It’s an incredibly popular way to plan for retirement and isn’t likely to go anywhere.
For passive real estate investors, there will always be significant opportunities to reduce and defer tax liability. It’s one of the best incentives for investing in real estate!
Don’t wait — start building your best financial future today.