One of the greatest advantages of investing in real estate is its tax implications. Passive real estate investors are uniquely poised to benefit from our existing tax structure. With that said, you must be aware of the avenues to save and take the steps to ensure them.
After all, a CPA can only help so much. So many of the tax advantages available to you demand the forethought of a strategic approach.
With that said, we always advise you consult a CPA or other tax professional on these matters. This is not legal advice.
6 Ways to Lower Your Tax Liability with Real Estate
1. Use an SDIRA
A self-directed IRA (SDIRA) allows investors to branch out beyond the limitations of a traditional IRA, allowing them to invest in real estate. There are complex rules governing a SDIRA, but in short, you can utilize this type of IRA to invest in real estate tax-deferred.
A few keys to remember:
- You cannot directly benefit from properties your IRA holds (including vacationing and residence).
- Neither can your relatives.
- You cannot self-deal (use your IRA to purchase, lease, or trade properties you already own).
2. Use a Pass-Through Entity
The 2017 tax laws added a 20% tax deduction of qualified business income (QBI) from your personal taxes when operating through a pass-through entity such as an LLC or S-Corp. You can also utilize this deduction within a sole proprietorship or partnership. Take advantage while you can – these benefits expire in 2025.
3. Employ the 1031 Exchange
A 1031 Exchange effectively allows real estate investors to “trade” one property for another (or several) of the same value. Because funds go through a qualified intermediary (QI), investors never directly earn any income from the sale of the property – thus, deferring capital gains taxes. Plan to perform an exchange well in advance. Once you’ve sold the property, it’s too late. This method demands advanced preparation and strict adherence to guidelines.
4. Buy and Hold
There’s a big difference between being charged short-term capital gains taxes and long-term capital gains taxes. If you hold a property for a least a year, you’ll benefit from long-term capital gains taxes, which come at much lower rates than their short-term counterparts. Uncle Sam rewards long-term, buy-and-hold investors. If you purchase an investment property, it is wise to plan to hold for at least one year to avoid being taxed at a higher rate.
5. Detail Deductions
Like any business, you’re able to deduct certain expenses related to your real estate investments. These include repairs and maintenance work (but NOT improvements that add value to the property), mortgage interest, property taxes, property management fees, advertising, legal fees, accounting fees, office space, and office supplies – among other things.
Talk to a CPA about what else you can deduct from your tax liability. Remember to keep records and keep them well-organized in the event of an audit.
6. Depreciation
Real estate is assumed to depreciate in value due to wear and tear, though this isn’t typically the reality. Real estate (more often than not) increases in value over time. This is particularly true of well-maintained investment properties. The depreciation deduction spans the “useful life” of the property, which for residential real estate is 27.5 years and 39 years for commercial properties.
Simply divide the property’s value by one of those numbers and see how much you can deduct. Just know that when you sell, if not within a structure like a 1031 Exchange, you are expected to pay typical income taxes on the depreciation claimed. This is depreciation recapture.
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