Diversifying your investment portfolio by purchasing real estate is a smart move. Real estate investors know rental properties experience long-term appreciation in value and produce valuable, recurring cash flow.
Investors also know rental properties can put them in a better position by saving them a lot of money during tax time.
Once you secure your first rental property, you know you must manage it and make necessary repairs. You also need to develop a tax strategy to keep most of the profits you earn.
There are many ways you can significantly reduce taxes on an investment property if you structure your real estate investments the right way. The tax code offers real estate investors built-in legal advantages that other types of investments do not have.
Continue reading to learn more about the tax benefits of real estate investing.
Reducing Taxes on Real Estate Investments
One of your primary responsibilities as a real estate investor is to keep detailed financial records of your rental property’s operation, management, and maintenance.
You want to keep detailed financial records because you can deduct all the expenses tied to the property. These deductions result in one of the biggest financial perks of being a real estate investor.
You can also write off most of the expenses that it takes to operate your real estate investing business. Some of the property and business expense deductions you can take advantage of include:
- Property taxes and insurance
- Mortgage interest
- Property management fees
- Maintenance costs
- Home office and business equipment expenses
- Legal and accounting fees
- Travel and mileage expenses
These deductions will reduce your taxable income and save you money when you file your taxes. Keep detailed, accurate receipts and records to document the expenses you claim and keep them for several years after filing taxes.
Talk to your accountant to see all the deductions available to you as a real estate investor.
Rental Property Depreciation
All buildings will deteriorate over time. Many things can cause a structure to deteriorate, including moisture, exposure to varying weather conditions, metal and concrete corrosion, faulty structural design and construction, and exposure to chemicals.
As a real estate investor, you can use the deterioration of your income-producing rental property to your advantage at tax time. Depreciation is the loss in value of your rental property because of deterioration.
Depreciation is an expense that you can use as a tax deduction to lower your taxable income and reduce your tax liability.
A rental property needs to meet several qualifications before you can receive the depreciation tax deduction. These qualifications include:
- You must own the property
- You must use the property for income-producing business activity
- The property can experience wear-and-tear
- The property must remain standing for more than one year
You can take the depreciation deduction for the expected life of your rental property. The IRS currently sets the expected life of a residential property at 27.5 years and 39 years for a commercial property.
When you sell the property, the IRS will make you pay the standard income tax rate on all the depreciation you claimed while you owned the property. This payment is called depreciation recapture.
You can avoid this tax burden through a 1031 exchange.
The 1031 Exchange
You can avoid depreciation recapture and capital gain taxes from the IRS in two ways. You can avoid selling your rental property, or you can claim a 1031 exchange.
Any profit you make from selling your rental property results in a capital gain. The taxes on certain capital gains will take a bite out of your investment returns.
An easy way to defer capital gain taxes indefinitely is through a 1031 exchange. This provision in the tax code allows a real estate investor to trade property for another property or multiple properties of equal value and defer any capital gain taxes on the trade.
You have 180 days to use the proceeds to purchase a new investment property when you sell an investment property. You can buy one or more properties that are like the property you sold.
The purchase price of the new property or properties must be of equal or greater value than the property you sold.
If you sell a single-family rental property and make a $300,000 profit, you can use the 1031 exchange to reinvest the money to purchase one or more income-producing properties.
These properties must have a cumulative value of at least $300,000. This reinvestment is known as a like-kind exchange. A qualified intermediary accepts the proceeds from the sold property and orchestrates the 1031 exchange.
The 1031 exchange is a tool for real estate investors to build wealth. It allows you to do several things, including:
- Compounding your profits by removing the need to pay capital gain taxes
- Create generational wealth by building equity and retaining capital for long-term appreciation
- Defer capital gain taxes as you upgrade your real estate investment holdings with each 1031 exchange
The 1031 exchange is a complex process that requires a real estate attorney and a real estate company specializing in these transactions.
This process does not require a legal team, and some experienced real estate investors can perform this process for themselves.
Hold Properties for More Than a Year
Flipping properties is a popular way for people to try to make quick money in real estate. Yet, flipping real estate come with a lot of risks.
You are most likely to break even or lose money flipping properties, which happens to most house flippers.
Part of the reason why this happens is that when you buy and sell a property at a profit in less than a year, the tax on the profit is at the normal income tax rate.
When you do this, the IRS may classify you as a self-employed dealer where your profits are subject to double FICA taxes.
You can avoid paying taxes at the regular income tax rate by holding your properties for more than a year before selling. This strategy can eliminate the risk of being labeled as a dealer.
The profits will be subject to lower capital gains taxes instead of the higher regular income tax rate.
Instead of flipping a house, a better strategy is to rent out the house for a minimum of a year before selling the home.
This strategy will financially benefit you in three ways:
- You will pay taxes at a lower rate
- You will earn some cash flow from monthly rent payments
- You can sell the home at a higher sale price due to appreciation
Take Advantage of Long-Term Capital Gains Capital gains taxes goes into effect when you sell an asset like real estate for a profit. There are short-term and long-term capital gains, and each one has a different impact on your taxes.
A short-term capital gain occurs when you profit from selling real estate within a year of purchasing the property. Any short-term capital gain is seen as regular income by the IRS and taxed at the standard tax rate.
A long-term capital gain occurs when you profit from selling real estate that you have owned for more than a year. Long-term capital gain taxes are significantly lower than short-term capital gains taxes.
You can save a lot of money by waiting more than a year before you sell a recently purchased rental property. In some cases, you may not have to pay any long-term capital gains taxes if your income is below a certain level.
My Final Thoughts On Reducing Taxes On An Investment Property
These are just some of the tax advantages you will experience as a real estate investor. Seek advice from your accountant and real estate attorney so that you can take advantage of all the tax benefits given to you as a rental property owner.
I would love to hear from you. Let me know how you have grown your real estate investment portfolio, increased your net worth, and saved money on taxes by using the many tax benefits available to real estate investors, in the comments section below.
Thank you very much and have a great day.