Tax Benefits of Real Estate Investing

When it comes to investing for the purposes of growing your wealth, you have options. Some might even say you have options galore.  

There are stocks and bonds, mutual funds, CDs, options, annuities, and whole life insurance.

There are different retirement savings plans and strategies, including 401ks and self directed IRAs.

You can invest in businesses and take an ownership stake in different types of ventures.

There are even digital assets, like cryptocurrency and NFTs. The list goes on and on.

But if you take a poll of the wealthy – the folks with seven-, eight-, and nine-figure net worths – you’ll find that they almost all believe in one type of investment above all else. I’m talking about real estate.

While any successful investor believes in diversification, it’s difficult not to play favorites.

Make no mistake about it, real estate is a favorite investing tool for the wealthy class. But it’s not exclusively reserved for people with massive bank accounts. Anyone – including you – can invest in real estate.

And the tax benefits associated with real estate are just one reason why you should do so.

The Power of Real Estate Investing

There are dozens of reasons to invest in real estate, including:

• Control. With most investments, including stocks, bonds, and even small equity investments in companies, you don’t have much control over things. But with real estate, you’re the one calling the shots. In other words, you decide when to buy and sell. And if it’s a single-family property, you can invest money into upgrades and control the process. If you’re a smart investor, this allows you to influence the rate of return over time.
• Appreciation. Real estate appreciates over time. With very rare exceptions (like a property that you overpaid for in a declining area of town), most real estate is going to increase in value. This includes residential, commercial, and even industrial. There are plenty of technical explanations for why this is true, but there’s also one very simple reason: They aren’t making any more of it. As the population increases over time, so does the demand for new places to live, new buildings, infrastructure, etc. And with land being a finite resource, macro demand will always increase over a five- or 10-year period.
• Cash flow. While appreciation increases your equity in the investment over time, you can also benefit from regular monthly cash flow (depending on the type of investment. Single-family rental properties are a great example. You get a check in the mail each month. Ideally, the size of this check is bigger than your monthly expenses.
• Recession-proof. While most real estate investments go down during a recession, the demand for rental properties actually increases with time. This makes it a great “recession-proof” investment when integrated into a large, well-diversified portfolio.

But, truth be told, most of these benefits pale in comparison to the tax advantages that you get when investing in real estate. If nothing else, these benefits are amplified by these tax benefits. So I’ll use the rest of this article to explore what they are and why they matter.

Top Tax Benefits of Real Estate Investing

There’s not just one tax benefit you get with real estate investments. There’s a whole list of them. And depending on the type of property and how you structure the investment, you may benefit from any or all of the following:

Mortgage interest deductions

There’s a long list of deductions you can take when investing in real estate. For each property that you own, you’re able to deduct things like mortgage interest, property taxes, property insurance, property maintenance, property management fees, etc. This alone, can increase your rate of return and make an investment worth your time and money.

Mortgage interest deductions 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).

Capital gains & property tax deductions

When you sell an investment for a profit, you owe taxes. One perk of owning real estate is that gains are taxed on a capital gains basis, rather than being taxed as ordinary income. This automatically qualifies you to pay a lower rate. And if you hold your investments for longer than a year, you can qualify for long-term capital gains taxes (either 0 percent, 15 percent, or 20 percent, based on income).

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.

Depreciation

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.

Additional Real Estate Investment Tax Benefits

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.

1031 Exchanges

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.

Opportunity Zones

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:

• Investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date the QOF is sold or December 31, 2026
• If the investment in the QOF is held for longer than 5 years, there is a 10 percent exclusion of the deferred gain. If held for more than 7 years, this increases to 15 percent.
• For investments held for at least 10 years, investors can potentially eliminate taxes on gains produced through the QOF.

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.

Capital Gains Exclusions

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.)

No FICA tax

All employee income is subject to a 15.3 percent FICA tax. Typically, your employer pays for half of this. However, if you’re self-employed, you have to cover the whole thing. Interestingly enough, the IRS doesn’t view rental real estate as self-employment business activity. This means it’s not taxed as “earned income.” The result? You get to keep a bigger portion of the net profit.

These are just some of the basic tax benefits. If you meet with a real estate tax professional who strategically structures real estate investments for a living, you may find a handful of other property-specific deductions or tax breaks. But no matter which way you slice it, the savings are significant.

Enjoy Real Estate Investment Tax Benefits With Invest.net

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!

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