Below, we take a look at essential real estate investing tax strategies that investors need to know to mitigate taxes and increase profits.
Investing in real estate is a great way to build wealth. It allows you to build equity in an appreciating asset and comes with several important tax benefits. For example, depreciation allows you to recover the cost of the property purchase price, homeowners can borrow against their equity for future investments, and investors are also able to deduct their mortgage or loan interest.
These real estate tax benefits make it incredibly enticing to invest in property in the US. They are designed to help investors minimize taxes by deducting overheads so that they can quickly scale their portfolios and achieve their financial goals.
In this article, we take a look at some of the key real estate investing tax strategies that investors need to know about if they’re to be successful with real estate.
In episode 6 of the Profitable Rental Podcast, Landlord Studio co-founder Logan Ransley sat down with Ryan Bakke, a certified public accountant, to talk about tax loopholes for real estate investors and how understanding the tax benefits of rental property can help you achieve your financial goals and grow your portfolio.
Below, we take a look at five common real estate investing tax strategies that investors need to know about. However, it’s worth noting that everyone’s situation is different, rules vary from city to city and state to state, and the tax code can be complex, so it’s advisable to talk with a licenced financial advisor or CPA to help you develop a strategy suitable for your situation.
Depreciation is one of the major tax benefits of rental property. It allows you to deduct the full value of the property (minus the land value) from your taxable income over what the IRS deems its useful life.
"Taxes are a huge piece of the puzzle when it comes to real estate investing, and there are a lot of tax benefits that are available to real estate investors. One of the big ones is depreciation," Ryan Bakke said.
Essentially, depreciation is the recovery of the costs to maintain the property through an annual tax deduction as a recompense for ‘wear and tear’ – the principle being that the property will decrease in value over time due to use. This can form a significant deduction each year.
The allowed annual depreciation amount is determined by the type of property and the purchase price of the property minus the value of the land it’s on (as the land itself does not depreciate).
The IRS deems residential property to have a useful life of 27.5 years and commercial property to have a useful life of 39 years.
For example, if you purchased a residential rental property for $350,000 and the land was valued at $75,000, you would have a property value of $275,000. You could then deduct $10,000 a year in depreciation for 27.5 years.
It’s important to note that some of this depreciated amount will be reclaimed by the IRS when you sell the property (whether or not you took the full allowable depreciation deduction) through the process of depreciation recapture.
An advanced tax strategy for real estate investors is to accelerate depreciation deductions on a property using a cost segregation study.
"A cost segregation allows you to accelerate the depreciation deductions on your property and take more depreciation upfront," Ryan explains.
It allows you to split out things like fixtures and furnishings that have a shorter 'useful life' and depreciate these faster.
Whilst this can be advantageous to maximize cash flow in the earlier years of property ownership, a cost segregation study can be challenging to do correctly and may not suit your long term investment strategy. Consult a licenced financial advisor or CPA.
One of the major tax benefits of rental property is the ability to deduct real estate operating expenses and reduce your overall taxable income.
Ryan Bakke went on to say, "Another big benefit is the ability to deduct expenses related to your rental property. So, any expenses that you incur in connection with your rental property, things like property management fees, repairs and maintenance, property taxes, insurance, those are all deductible expenses that can help reduce your taxable income."
In order to maximize your end of year deductions real estate investors should leverage modern real estate accounting software like Landlord Studio to keep accurate and up to date records. At the end of the year simply run our comprehensive financial reports including P&L and Schedule E reports to make filing your Schedule E as easy as possible.
Social security and Medicare income taxes of 15.3% are generally split evenly between you and your current employer. However, if you don’t have an employer because you are self-employed, then you are entirely responsible for paying this 15.3%.
However, rental income, while taxed at standard income tax rates, is not subject to FICA taxes. This means even if you are self-employed, any income relating to your rental properties is immune to both the social security and Medicare taxes you would otherwise pay on either a 1099 or W-2.
This is a strategy for deferring capital gains made on the sale of an investment property. To encourage investment in rural and financially distressed areas, the Tax Cuts and Job Act of 2017 designated approximately 9,000 areas as Opportunity Zones. Investors can invest capital gains earned from selling other investment properties into investments in these areas as a way of deferring capital gains tax.
A 1031 exchange is another strategy for deferring capital gains taxes.
Ryan Bakke explained "If you sell a rental property and you reinvest the proceeds into another like-kind property, you can defer the capital gains tax that you would otherwise owe on that sale. So that can be a really valuable strategy for real estate investors who are looking to sell one property and buy another and not have to pay taxes on that gain."
Essentially, a 1031 exchange allows you to exchange one real estate investment property for another "like-kind investment". A "like-kind investment" means you can’t swap a residential rental for an Airbnb or a commercial property, for example. But you can roll over capital gains from one residential property to another, effectively avoiding taxes until you cash out.
There are a few stipulations, however. You will need to hold the new property for at least 1 year, and the two properties must meet the following criteria to qualify as a 1031 exchange:
Whilst anyone that has invested in real estate can tell you that rental income is anything but passive, any income that is earned through rental-related business activity in which the investor does not actively participate (see our article on passive activity) is deemed to be passive income by the IRS.
The Tax Cuts and Jobs Act 2017 established a new pass-through tax deduction for rental property owners. This allows investors to deduct up to 20% of their net rental income, or 5% of the original cost of the property plus 25% of employee payroll expenses.
This deduction, established in 2018, is related specifically to income tax and is unrelated to rental deductions. This special income deduction is scheduled to expire in 2025.
The most simple way to think about it is that repairs and maintenance are regular one-off expenditures that are incurred in order to keep your property in a safe and habitable working condition. Essentially, these expenses are necessary for maintaining your property in its original condition. On the other hand, a capital improvement is an addition or an improvement that adds value to the property, increases its useful life, or adapts it to a new use.
For example, should the AC break or the roof leak and you get them fixed, this would be deemed a repair. However, if you were to replace the entire AC or the entire roof, this would most likely be deemed a capital improvement.
The distinction between repairs and capital improvements is sometimes hard to determine and has historically been a source of disputes between rental property owners and the IRS. For this reason, the IRS released extensive official guidance on this topic in 2014. The guidance is a must-read for rental property owners.
When determining the useful life of a capital expense, there isn’t much wiggle room. The IRS specifies and defines the categories that a capital expense will fall under and defines the class lives as either 5, 7, 15, or 27.5. You may, however, be able to use accelerated depreciation on items that would otherwise fall into either the 5, 7, or 15 year property classes.
Learn more about accelerated depreciation.
In most scenarios, you can deduct the interest paid on any loan in the year that this expense is incurred. On the other hand, associated loan costs such as points, origination fees, credit reports, bank fees, fees for appraisals required by the lender, mortgage insurance, assumption fees (if any), and application fees, are capitalized and depreciated over the life of the loan (e.g. 30 years).