One of the most compelling reasons to choose to invest in real estate over other investments is the vast tax benefits. In fact, it’s one of the main points of discussion each time we talk about why to invest in real estate. However, navigating the tax code and legal nuance can be a mystifying exercise in frustration.This is why, when dealing with taxes and tax deductions, we recommend working with a CPA or other tax professional who specifically has experience working with real estate investors.
In the wake of last year’s tax reform, many of the deductions and benefits have been enhanced. With that said, here is your quick rundown of tax benefits to remember!
Can’t-Miss Tax Deductions and Benefits for Real Estate Investors
In real estate investment, depreciation is among the most well-known and by far the largest opportunity to reduce your taxes without affecting your cash flow. Depreciation, simply put, is a deduction on things that wear down and degrade in value over time.
As an owner, you are able to deduct portions of the value of your residential property building (land does not qualify) from your taxes for 27.5 years. Because properties often last much longer than this and there is a decreased risk of loss, this is a deduction you can’t afford to skip. You could save thousands each year in deductions through depreciation alone!
Long-Term Capital Gains
There are two types of capital gains: short-term and long-term. For the buy-and-hold real estate investor, long-term capital gains are what you will most often deal with. They apply to properties held for more than one year.
Because there are no special considerations for short-term capital gains, you will pay according to your normal tax bracket as defined by the IRS. (Remember, tax brackets were altered this past year!)
Long-term capital gains, however, play by different rules. You are taxed at a rate of 0 percent, 10 percent, or 15 percent depending on your income bracket. This is considerably lower than short-term gains rates, which can range from 10 to 37 percent.
You could, in effect, make the same amount as the next guy running his own business, but pay significantly less in taxes simply by virtue of where that income originates and how the IRS treats it.
The Pass-Through Deduction
The pass-through deduction is among the deductions beefed up by recent tax reform. This is a deduction of up to 20 percent. However, there are requirements one must qualify for. This deduction is specific to certain businesses and trades.
In order to qualify, you must:
- Hold your rental property through a pass-through entity, such as an LLC
- Earn a net profit within the tax year in question through your property
- Your taxable income exceeds your deductions
The key, if trying to capitalize on this deduction, is that your rental activity qualifies as a business. That means you are engaging continuously and regularly. This, however, doesn’t mean that you have to do all the work. You can still work with companies and hire managers. The IRS hasn’t made the distinction clear between a business-qualifying rental property and otherwise.
Thankfully, the pass-through deduction is subject to the “safe harbor” rule. This means that, if you follow these guidelines, the IRS cannot bother you. So how do you qualify for a safe harbor?
- Keep separate books to record income and expenses for each rental property you own.
- Perform a minimum of 250 real estate service hours each year.
- Keep a record of real estate services performed.
As a reminder, those 250 service hours don’t have to be performed by you, the owner. So turnkey investors are in luck!
Repairs and Maintenance
Standard repairs and maintenance can be deducted from your yearly taxes. Homeowners cannot deduct repairs and maintenance (they can deduct home improvement!), so take advantage of this opportunity throughout each tax year.
Did you hire a CPA to help sort through your taxes? A financial adviser to help develop your investment portfolio? Everything from legal and accounting fees to property management and contractor services can be written off as a deduction.
Taxes and Insurance
Your property taxes, school district taxes, and any taxes associated with owning a rental property (excluding income taxes) are deductible. In the same way, you can deduct the cost of insurance for your property: including provisions like homeowner, flood, and liability. These go on your Schedule E tax form.
Interest is also deductible! Paying a mortgage on your investment property? Deduct the interest. Take out a loan to improve the property? Deduct the interest. If you have any loans used to fund your rental properties, you have a potential deduction on your hands.
Lastly, there is the famous 1031 Exchange. We’ve written both a guide to the 1031 Exchange and have also interviewed two professionals who work for or with Memphis Invest to help investors accomplish 1031 Exchanges successfully.
In the briefest of terms, you can defer capital gains taxes (like the ones we discussed above) by essentially trading a like-kind property for another (or several) of equal value. You are essentially using the sale of a property to diversify your portfolio while circumventing taxes associated with the sale. Many investors use this to “level-jump” and get higher valued properties or several properties with the sale of a property that has appreciated over time.
1031 Exchanges, however, can be complex. Don’t forget to read our full guide!
Real estate investors flourish when they understand all their avenues to generate and protect their wealth. Join the experts at Memphis Invest and don’t miss a beat!