Tax Optimization for Real Estate Investing
Real estate investing is one of the most powerful wealth building tools that we have access to as investors. And much of this is predicated on the various tax advantages and strategies that can be leveraged to generate oversized ROI.
Without digging too much into the nitty gritty details of tax law, it’s important to understand that the IRS offers benefits in the form of deductions and credits as a way of incentivizing investors to make specific choices. In other words, the IRS wants you to pay lower taxes, because it means you’re following the path they’ve intentionally laid out for creating value.
Take property tax deductions as an example. The reason the IRS gives deductions on property taxes is that they want people to buy real estate. Because they know that when people buy real estate, they populate communities, bring in businesses, spend money, etc.
So while some people on the outside looking in like to point fingers and say real estate investors are just “gaming the system” – that’s not true. The IRS and local governments put tax laws, deductions, and credits in place to encourage folks like us – real estate investors – to invest.
In this guide, we’re going to discuss some of the best tax optimization strategies for real estate investing, so that you can maximize your ROI as an investor.
Basic Tax Optimization Strategies for Real Estate Investing
There are two categories of tax optimization for real estate investing. There are basic ones and advanced ones. Let’s begin with the basics. (Which, by the way, can give you some pretty amazing results. We’re just calling them “basic” because they’re the most commonly used, but the results are anything but basic.)
Mortgage Interest
Every penny you pay in interest on your mortgage loan can be deducted from your taxable income. This doesn’t mean every penny of your mortgage payment, but rather every cent of mortgage interest. For example, let’s say your mortgage payment on an investment property is $1,000 (for clean, simple math). If $600 of that monthly payment is interest, $300 is principal, and $100 goes into escrow for insurance, you can deduct $600 per month from your income on that property.
Property Taxes
You pay taxes on your property every year, and guess what? You can deduct those too. This helps offset the sting of property taxes and reduces your overall tax burden. In states that have extremely high property tax – like California or New York – this alone can save you thousands of dollars per property per year.
Maintenance and Repairs
Keeping your rental property in tip-top shape is crucial, and the good news is, those repairs and maintenance costs are deductible. This includes things like fixing leaky faucets, patching up holes in the wall, or replacing a broken appliance. Just remember, these need to be regular upkeep costs, not major improvements that add value to the property (we'll get to those later).
Depreciation
This is a super powerful tax benefit for real estate investors. Depreciation allows you to deduct a portion of the cost of your property (excluding the land) over a set number of years. Basically, the IRS acknowledges that buildings wear down over time, so you get a tax break to account for that. There are even special accelerated depreciation methods that let you deduct a larger portion of the cost upfront, which can significantly reduce your tax bill in the early years of ownership. Here's an example: Let's say you buy a rental property for $100,000 (land value is $20,000 and building value is $80,000). The IRS allows you to depreciate the building over 27.5 years. This means you can deduct a portion of the $80,000 building value each year on your taxes. With accelerated depreciation, you might be able to deduct a much larger portion in the first few years, which can be a huge tax saving.
Deferring Capital Gains (1031 Exchange)
When you sell an investment property that you have not lived in as your primary residence for at least two of the previous five years, you owe capital gains taxes on the profits that you make. In other words, if you bought the property for $100,000 and you sell it for $175,000 a few years later, you will owe taxes on the $75,000 in profit. Unless you defer those taxes through a strategic maneuver known as a 1031 Exchange. In order for a 1031 Exchange to work, you have to take the proceeds from the sale and buy what the IRS calls a “like-kind” property within 180 days. This simply means you have to find a similar property – not necessarily in price or location – just in terms of the type of building. Then you have to reinvest the proceeds into that property. This defers the taxes you pay – effectively kicking the can down the road. The key here is to follow the rules about “like-kind” properties. You can’t sell a single-family rental property and then try to perform a 1031 Exchange into a vacation condo at the beach for your family’s personal use. It doesn’t work like that. You would have to buy another single-family rental property. The other key is that time limit mentioned above. You have a very short window of time to conduct a 1031 Exchange. Make sure you follow all rules and protocol so that you don’t unintentionally miss out on the chance to defer your capital gains taxes.
Advanced Tax Optimization Strategies for Real Estate Investing
Now that we’ve covered some basic tax optimization for real estate investing, let’s dig into a few of the more advanced options that can really give you an amazing ROI. These include:
Entity/Business Structure
How you hold your real estate investments can impact your taxes. If you haven’t already, it would be smart to speak to a CPA or tax advisor about the best type of entity for your real estate holdings. The most common ones include:
- Sole Proprietorship: It doesn’t really take anything special to set up a sole proprietorship. In fact, if you don’t do anything, you’re essentially recognized as a sole proprietorship. This just means there’s no separation between you and your real estate investment business. All income and losses flow directly through your personal tax return. There’s also no legal/bankruptcy protection with this approach.
- Limited Liability Company (LLC): If you want some personal liability protection – meaning you’re slightly protected in the case that there are business debts or lawsuits – you can set up an LLC and choose to be taxed as a sole proprietorship or as a corporation.
- S-Corporation: Similar to an LLC in terms of liability protection, but with a unique tax structure. S corporations avoid double taxation (where both the corporation and shareholders are taxed on profits). However, there are stricter regulations and qualification requirements for S corporations.
- C-Corporation: Finally, there are C Corporations, which are separate legal entities from the owner. As a result they’re subject to double taxation; however, they offer much greater flexibility in how profits are distributed.
It’s impossible to make a blanket statement about which entity or structure is right for all situations; however, the good news is that there are options. By consulting with some tax professionals, you can figure out which one makes the most sense in your context.
Opportunity Zones
If you remember, tax strategies are made possible by the fact that the government and IRS incentivize specific investing activity. That’s precisely why the government has created designated “Opportunity Zones.” These zones are economically disadvantaged areas where the government wants to encourage investment and revitalization.
By investing in a qualified Opportunity Zone property, you get some additional tax benefits and perks. For starters, you can always defer capital gains taxes on the sale of another investment property by reinvesting the proceeds into a qualified Opportunity Fund. (Even if you don’t qualify for a traditional 1031 Exchange, you might qualify for deferring capital gains through an Opportunity Zone property.)
On top of the deferred taxes, there’s also an opportunity to qualify for a partial reduction in the total capital gains taxes you ultimately owe based on how long you hold the property for. As is the case with any tax strategy, there are lots of qualifying factors, so make sure you speak with a tax advisor to see what it would look like for a specific investment.
Passive Activity Rules
Real estate investing can be considered "passive" or "active" depending on your level of involvement. The IRS has "passive activity rules" that limit how much passive income you can offset with passive losses from other activities.
Understanding these rules is crucial, especially if you have multiple passive income streams or own several investment properties. A tax advisor can help you navigate these rules and ensure you're maximizing your deductions while staying compliant with the IRS.
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As you look to build a real estate portfolio, consider working with our team here at Invest.net. We offer diversification through proprietary, curated investment opportunities in real estate and private equity. We’re open to both accredited and institutional investors, giving you access to investments that you might not otherwise find on your own.
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