In most cases, passive real estate investors aren’t in it solely for cash flow. One of the best reasons to invest in SFRs is simple: you reap rewards from cash flow, appreciation, and tax benefits. The taxes, in fact, are one of the main reasons people choose real estate!
But what are those benefits? And what should investors look for in individual investment markets? After all, local and state taxes can significantly impact the effectiveness of these policies. Here’s what you need to know!
General Tax Benefits for Real Estate Investors
Depreciation Benefits
Tax laws often allow real estate investors to claim depreciation on their properties, reducing taxable income and lowering overall tax liabilities. The thought is that tangible, physical assets decay and lose value over time. Because of this, the IRS allows investors to claim a tax deduction for property depreciation. (A typical residential rental property in the U.S. depreciates at a 3.636% rate each year for 27.5 years.)
Of course, the rub is that real estate – especially a well-maintained, well-managed property – increases in value over time!
1031 Exchange Opportunities
In the United States, the 1031 exchange allows investors to defer capital gains taxes when they sell a property and reinvest the proceeds into a “like-kind” property. This is a complex strategy that demands plenty of planning ahead – always consult tax professionals!
Further Reading: Use the 1031 Exchange to Maximize Money You’ve Already Invested
Tax Credits & Capital Gains Taxes
Certain investments, such as those in renewable energy or low-income housing, may qualify for tax credits that significantly reduce tax burdens. There’s also the matter of capital gains. Buy-and-hold investors that own their properties for more than a year benefit from long-term capital gains taxed at a lower rate than short-term capital gains.
…But your real estate market matters!
Though these advantages are afforded to real estate investors across U.S. housing markets, taxes vary by state and county. Your real estate market really matters. What may seem like a deterrent in one area may pay off in another. Keep reading!
Market-Specific Tax Considerations for Real Estate Investors
Property Taxes
Areas with lower property tax rates can be more attractive to investors as they reduce ongoing holding costs and increase potential returns. If you utilize traditional financing, your property tax payments are rolled into payment to your escrow. Any annual changes will result in adjusted monthly mortgage payments and, at times, a refund from escrow.
Many of our markets at REI Nation boast low effective property tax rates, like Alabama (0.40%), Arkansas (0.64%), and Tennessee (0.67%). But let’s talk about Texas. With an effective property tax rate of 1.68%, it has the 6th highest rate in the nation. So, what makes it so attractive to real estate investors anyway?
There are a few factors to consider: overall market stability, rental demand, and property appreciation. Texas is home to markets that bounced back quickly from the Great Recession and flourished throughout the pandemic. Historic real estate performance is an incentive.
Income Taxes
Speaking of incentives, Texas is one of a handful of states with no personal income tax. In Texas, you may have to pay a 1% marginal tax rate for real estate transactions and rental income if your annual revenue exceeds $1,030,000. Even then, there are ways to avoid this tax through your business entities.
Still, a lack of income tax certainly helps offset the sting of property tax rates – even if you’re still on the hook for federal income tax. This also means that Texas doesn’t have a capital gains tax. However, you will want to be mindful of the policies where you live. Some may require you to pay even if you made the income in an income-tax-free state.
Tax Exemptions or Incentives
Some regions offer tax exemptions or incentives for specific real estate types, such as historic properties, affordable housing developments, or renewable energy projects. Investigating these opportunities and weighing the pros and cons is worth your time.
Stable Tax Policies
We often say that market stability is one of the best reasons to invest somewhere. Unpredictability disrupts cash flow and can make calculations more difficult. That same is true of taxes! A stable and predictable tax environment is crucial for investors to plan their investments effectively without unexpected tax changes throwing a wrench into their plans.
At the end of the day, there will always be trade-offs for investors to consider. Do your due diligence in considering the tax implications of your real estate acquisitions. We recommend consulting with a tax professional, especially one versed in real estate investing, to be sure you’re getting the most out of your market.
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