Investing in real estate is considered one of the most effective paths to financial freedom. It can offer incredible returns without a ton of active involvement (depending on how you're investing) and offers even better passive income tax benefits, which are most sought after by real estate investors.
Taking advantage of these federal tax incentives can help you build long-term wealth and create a steady income stream by lessening certain tax liabilities. As physicians, we should be looking for all the tax incentives available to us.
In addition, come tax season, real estate investing can provide significant benefits which can let you keep more of what you make. However, learning about these tax incentives can require a lot of research on your part, so in this article, I will cover different types of passive income tax breaks available to you as real estate investors.
Before we dive in, I want to clarify that I am not a tax professional, and any of the strategies discussed in this post is not a replacement for tax advice. Please consult your CPA or tax professional to determine the right plan for you.
Quick Overview of Real Estate Taxes That You Might Owe
Tax laws can be complex and especially fluid, so work with a trusted tax accountant to get the most benefit. However, it's helpful to have a basic understanding of real estate taxes that you might be on the hook for.
If you're a homeowner, you're probably familiar with property taxes. You pay these taxes to your local government based on the assessed value of your land and the building structure on it. However, property taxes for commercial real estate are typically higher than residential buildings.
In addition, in certain jurisdictions, non-real estate property items like personal business equipment and furniture can be taxable. In this situation, a tax assessor will determine the collective value of your personal property and send you the tax bill.
Real Estate Income Taxes
Everything you earn from your rental property is taxable, just like your ordinary income. But there are certain expenses you can deduct using Tax Form 1044 Schedule E for reporting supplemental income and losses. I will cover these deductible expenses shortly.
Capital Gains Taxes
When you sell an investment property for a profit, you are required to pay capital gains tax. Homeowners can exclude up to $250,000 and up to $500,000 if filing jointly in capital gains taxes. Real estate investors don't qualify for this exclusion as these investment properties aren't their primary residences.
If you sell a property within one year of holding, you will incur short-term capital gains, taxed like the ordinary income between 10% to 37%, depending on your income bracket. But if you decide to hold for a year or longer, you will owe significantly lower taxes between 0% to 20% per your income bracket.
An Overview of Tax Breaks for Real Estate Investors
While nobody enjoys paying taxes, there are numerous Tax Breaks that an investor can capture to reduce the amount they owe to Uncle Sam. Here are some of the most widely used real estate tax benefit strategies:
1. Capture Asset Depreciation
Asset depreciation is the process of recovering your costs by deducting a property's value across its expected life due to normal wear and tear. However, you cannot write off the entire amount in year one of ownership. Deduct this amount over 27.5 years for residential property and over 39 years for commercial real estate. Per IRS, depreciation is eligible only for rental properties producing rental income for at least a year.
For tax purposes, depreciation is always considered a net loss on a real estate investment regardless of any profit it makes. This federal tax incentive is one of the biggest deductions for investors on their yearly taxable rental income.
With current laws in place, investors can take place of bonus depreciation to accelerate depreciation early on in the life of the investment. Over the next few years, this benefit will decrease in a linear fashion so it would be worth it to look into this sooner rather than alter.
2. Deduct Your Expenses
A deduction is a primary and compelling tax benefit for real estate investors. Rental properties can claim several expenses as deductions tied directly to the business operations, such as:
- Property Taxes – You might be able to deduct up to $10,000 as a combination of state and local property taxes or sales taxes on your personal property like primary home, vacation home, land, vehicles, or property outside the US.
- Mortgage Interest Payment – Mortgage interest payment can be one of the most significant expenses for investors, but that is deductible when the loan amount is either used to acquire a new property or improve an existing one. This deduction is applicable for a principal amount of up to $750,000.
- Property Repair and Maintenance Costs – Repair work necessary for building upkeep can be claimed as a deduction by a landlord in the same year of maintenance work done. Repair work typically includes painting, plasterwork, replacing broken windows, etc.
- Property Insurance – Typically, homeowners' insurance isn't tax-deductible. Still, if a part of a home is used as dedicated office space by the policyholder, you might be able to claim a certain percentage of the insurance premium on your tax returns.
- Property Management Fees – Whether a landlord manages the property himself or hires a property management company, the property management fees are tax-deductible. For practical purposes, it's easier to estimate your property management costs when handled by a property management company.
In addition to the above benefits, real estate investors can take further advantage of tax deductions for business-related expenses as a limited liability company or limited partnership, such as:
- Office Space or Home Office
- Professional Fees
- Software Tools and Business Equipment
- Education and Membership Fees
- Advertising Expenses
- Travel and Mileage Expenses
3. Understand the Basics of Section 1031 Exchange
Section 1031 in the IRS tax code is a legal transaction that allows real estate investors to trade an investment property for a similar kind of investment property to defer taxes or depreciation recapture upon sale.
As a real estate investor, if you sell a property after holding it for several years or make a substantial profit on a deal, then the 1031 Exchange strategy can be your best friend. This rule allows you to defer paying taxes indefinitely as long as you don't receive any proceeds from the sale.
The basic idea is if you file a 1031 exchange before a sale and use the monetary benefit from that deal to buy another property, then you can continue to defer paying taxes until you decide to cash out.
4. FICA Tax for Self-Employment
If you are employed, you and your employer evenly split 15.3% of social security and Medicare taxes, but you are responsible for the entire amount if you're self-employed. Although rental income is taxable as ordinary income, you are not required to pay FICA taxes on any gains from a rental property.
5. Pass-Through Deductions
When you earn passive income from rental property as a sole proprietor, partnership, LLC, or S Corporation, your earnings are considered Qualified Business Income. Historically, passive income hasn't been eligible for pass-through tax benefits, but the Tax Cuts and Jobs Act of 2017 initiated a new pass-through tax deduction for rental property owners. This pass-through deduction allows you to deduct up to 20% of taxes on your qualified business income.
6. Take Advantage of Opportunity Zones
Opportunity zones are designated geographic areas identified as economically distressed communities and were created as part of the 2017 Tax Cuts and Jobs Act to support the development of low-income neighborhoods by offering tax breaks. Currently, there are 8,700 opportunity zones nationally with a population of over 35 million.
Investors can participate in this federal initiative and defer capital gains taxes by reinvesting that money in qualified opportunity funds. For example, if you can invest and hold for five years, you can defer capital gains taxes by 10%; likewise, if you can wait for seven years, you can defer taxes by 15%. Moreover, if you can stay invested for ten years, your entire capital gains can be tax-free.
Real estate investing offers some of the highest tax incentives available today, yet many are unaware of these opportunities. The key is to understand tax benefits ideal for your situation to continue building wealth and staying on track to financial freedom by mitigating avoidable fees.
If your CPA isn't talking about these tax advantages, it's worth it to have a conversation about it.