Real estate has and always will be one of the most lucrative and appealing asset classes for investors who want to own something tangible that can produce a sizable ROI over both the short-term and long-term. And while most people think about real estate ROI in terms of cash flow, it’s actually the tax benefits that seasoned real estate investors are usually most interested in.
Real estate investment tax benefits reach deep and wide – significantly reducing an investor’s overall tax burden both in the investment itself, as well as with their larger financial picture. These benefits include deductions, exemptions, and even tax credits – all of which combine together to incentivize investors.
Depending on the type of real estate, the financial situation of the investor, and other factors, there could be as many as a dozen different tax benefits associated with a real estate investment. However, there are usually three core tax benefits that investors care most about.
Depreciation is a powerful tax benefit that real estate investors have access to when buying properties. It allows the property owner to reduce their taxable income each year by accounting for the “perceived” decrease in value of the property over time (due to aging, wear and tear, and other factors).
Depreciation is a non-cash deduction that reflects the cost of an investment property over its useful life as determined by the IRS. For residential rental properties, this period is generally set at 27.5 years, while commercial properties are depreciated over 39 years. This means that investors can deduct a portion of the property’s cost from their taxes each year, spreading the initial investment cost over many years.
The depreciation deduction is calculated by dividing the cost basis of the property – excluding the land, as land is not depreciable – by the useful life of the property. For example, if a residential rental property (excluding land) is purchased for $275,000, the annual depreciation would be $10,000 ($275,000 / 27.5 years).
When an investor depreciates a property, they may be able to offset most or all of the income that was generated from that profit for that year. However – and this is an important note – the deduction only applies to the income generated from that profit. In other words, an investor can’t use depreciation to offset income made from a W-2 or 1099 job.
It’s important to note that depreciation is recaptured upon the sale of the property. This means that the IRS will tax the cumulative amount of depreciation taken over the years at a specific recapture rate, which is currently 25 percent. This tax is applied to the portion of the sales gain attributable to the depreciation deductions.
The second big tax benefit for real estate investments is mortgage interest deductions. These allow investors to reduce their taxable income by deducting the interest they pay on a mortgage used to purchase or improve the property.
In order to qualify for a mortgage interest deduction, the loan must actually be secured by the property. (In other words, the lender must have the ability to take ownership of the property in case of a default.)
The amount of interest that is allowed to be deducted is based on the interest portion of the mortgage payment only. In other words, the premium, insurance, and any other added expenses or fees that make up the total monthly payment are not deductible. So if your payment is $3,000 and $1,700 of that payment is mortgage interest, only $1,700 per month – or $20,400 over the course of the year – can be deducted. The other $1,300 per month is not deductible for tax purposes.
Deducting mortgage interest effectively allows real estate investors to decrease the net cost of their mortgage payments. Using the example above, someone who is taxed at a 30 percent tax rate would basically offset their monthly mortgage payment by $510 per month (0.30 x $1,700).
For many investors, property taxes can be a huge expense that can effectively make an investment non-viable. Thankfully, property tax can be deducted in most cases. When combined with the other two core tax benefits – depreciation and mortgage interest deductions – property tax deductions give investors a powerful three-headed monster.
According to the IRS, real estate investors are eligible to deduct property taxes paid on any real estate property they own, provided these taxes are based on the assessed value of the property. This includes taxes for general community and government benefits. Important note: The deduction applies only to taxes actually paid during the year.
Suppose an investor owns a rental property valued at $400,000, and the local property tax rate is 1.25 percent. The annual property tax would be $5,000. This entire amount is deductible from the rental income earned on the property, effectively reducing the investor’s taxable income by the same amount.
By reducing taxable rental income, the property tax deduction directly decreases the amount of tax payable by the investor, improving the overall cash flow of the investment.
While depreciation, mortgage interest deductions, and property tax deductions are the three most important and valuable tax benefits, there are plenty of other benefits and perks for savvy real estate investors to leverage in different scenarios.
A 1031 exchange, named after Section 1031 of the IRS Code, allows investors to defer paying capital gains taxes on an investment property when it is sold, as long as another “like-kind” property is purchased with the profit gained by the sale.
A 1031 exchange is a very popular and effective tool that allows real estate investors to essentially grow their portfolio over time without having to experience any immediate tax burdens.
There are some key rules involved with 1031 exchanges. For starters, the investor has 45 days to identify up to three different potential replacement properties. Then the replacement property must be purchased within 180 days of the sale of the original property. Finally, as mentioned earlier, it must be “like-kind” – meaning of the same asset class or nature as the original property.
An opportunity zone is an economically distressed community or area where local governments incentivize investors by offering preferential tax treatment. While it all depends on the specific structure of the opportunity zone in question, benefits include:
Again, opportunity zones only exist in certain distressed communities or areas. However, if you run across good investment options in these areas, these additional tax benefits can help the deal make sense from a tax stance.
If an investor has lived in one of their investment properties as a primary residence for at least two of the five years preceding the sale, they’re able to exclude up to $250,000 of capital gains from their income. This number scales up to $500,000 if married and filing jointly.
In addition to satisfying the two-year rule, it’s also worth noting that the exclusion is only available once every two years (and the exclusion does not apply to depreciation recapture). In most cases capital gains exclusions don’t apply – as most investors aren’t living in their properties as a primary residence – but this can come into play in unique situations. (For example, if the investment property is a duplex and the investor lives in one half of the property.)
At Invest.net, we have a team of real estate and tax professionals working together to help our clients source the best investment opportunities that make the most sense on multiple levels. Whether you’re trying to maximize cash flow, access major tax benefits, or do a combination of the two, we can help procure the right deals for your portfolio!
