Investing in real estate provides people with a way to put their money into something tangible and can, if done properly, provide excellent returns. Even people who don’t have the money to buy properties outright can get into real estate investing by purchasing shares of a Real Estate Investment Trust (REIT.)
Our Addition Financial members often come to us with investment questions, including queries about how the investments they make will impact their taxes. It’s always a good idea to understand tax benefits before investing, so with that in mind, here are nine tax benefits of real estate investing that you should know.
How is real estate investment income taxed?
Before you make any real estate investment, you should have some basic information about how investments (and the income from them) are taxed.
The first issue is rent. If you buy residential or commercial real estate that you rent to tenants, you will need to pay taxes on your rental income. The Internal Revenue Service classifies rental income as ordinary income. (It is not classified as earned income, which has other tax advantages that we’ll discuss later.) That means that you’ll need to report your rental income to the IRS and pay income taxes on it. The tax percentage you pay will depend on your total income level. It’s possible that the rental income you earn will push you into a higher income bracket, thus increasing the amount of tax you must pay. You may be able to deduct certain expenses to offset these costs, something we’ll talk about more in the next section.
Any time you sell real estate, you’ll need to be mindful of the capital gains tax rules and how they apply to you. If you sell a property that you have owned for less than one year, your proceeds will be taxed at the ordinary rate. On the other hand, selling a property you’ve owned for over a year changes things because those proceeds will be taxed at the lower capital gains rate. Depending on your total taxable income, they may be taxed at 0%, 15% or 20%.
REITs are real estate investments that pay dividends. The income from those dividends is taxed as ordinary income, the same as rental income. There may be some options to reduce your taxes by reinvesting dividend income in a traditional IRA. If you did so, you would not pay taxes until you withdraw money from your IRA.
9 investment property tax benefits
If you decide to invest in real estate, there are some important tax benefits you should know about as a real estate investor. Here are nine to be aware of.
#1: Depreciation
If you own rental property, you have the option to claim a tax deduction for depreciation over the life of the property. According to the IRS, lifetime is defined as 27.5 years for residential property and 39 years for commercial property.
For example, if you purchased a residential property like an apartment building and paid $500,000 for it, you would take the appraised value of the property and divide it by the number of years of depreciation. That would mean a deduction of $18,181.82 per year. You should keep in mind, though, that when you sell the property you’ll need to pay the standard income tax rate on any depreciation you have claimed, something known as depreciation recapture.
#2: Ordinary expense and maintenance write-offs
Another tax benefit of owning rental property is that you can write off ordinary expenses associated with the maintenance and repair of your property. For example, if you repave a parking lot, repaint apartments or repair fencing, you’re spending money to maintain the value of the property and you can deduct those expenses.
It’s important in this case to differentiate between repairs and improvements, which may not be tax deductible. Business expenses such as insurance and advertising may also be deductible, so make sure to check with an accountant to take advantage of every deduction available to you.
#3: Mortgage interest deduction
Unlike with personal property, there is not a separate mortgage interest deduction for investment properties, but that doesn’t mean you can’t deduct your mortgage interest. We’ve listed it separately because we want to make sure that investors understand how to take advantage of this tax benefit.
There is no limit on the amount of mortgage interest you may deduct on investment property. However, your mortgage interest must be deducted as a business expense. Your lender will provide you with Form 1098 each year to confirm the amount you paid in mortgage interest.
#4: Property tax and property insurance deduction
Speaking of business expenses, there’s another category we want to single out. There isn’t a separate category for a property tax or property insurance deduction; however, as is the case with mortgage interest, you can deduct both as business expenses.
Other expenses that may be deducted include property management fees, advertising, office space, business equipment, travel expenses and legal or accounting fees incurred for your investment properties.
#5: Pass-through deduction
Many people who purchase real estate as an investment do so by creating a Limited Liability Company (LLC), S Corporation or partnership. If you do that, your business income will be classified as pass-through income, because you’ll need to report it on your personal federal income tax return.
If you have pass-through income, you can deduct up to 20% of your real estate investment income when you file your personal taxes. This tax benefit is available (as of now) through 2025 and will expire that year unless Congress renews it. Known as the Qualified Business Income deduction, it may also be applied to dividend income from REITs. You can read more about it here.
#6: Capital gains tax
One of the biggest advantages of real estate investing comes when you sell the property you purchased as an investment. Provided you owned the property for more than a year, you won’t be taxed at the ordinary income tax rate for your income bracket. Instead, you’ll pay the lower capital gains tax rate. Capital gains are taxed at three levels depending on what your income bracket is, as follows:
- 0% for:
- Single taxpayers or married filing separately earning up to $44.625
- Married filing jointly earning up to $89,250
- Single heads of household earning up to $59,750
- 15% for:
- Single taxpayers or married filing separately earning between $44,626 and $492,300
- Married filing jointly earning between $89,251 and $553,850
- Single heads of household earning between $59,751 and $523,050
- 20% for:
- Single taxpayers or married filing separately earning $492,301 or more
- Married filing jointly earning $553,851 or more
- Single heads of household earning $523,051 or more
These rates are for the 2023 tax year.
#7: 1031 exchange
A 1031 exchange is a tax incentive designed to encourage real estate investors to reinvest their capital gains in new properties. The rule is that if you use your capital gains from a real estate sale to invest in another property of equal or greater value, you may defer paying any capital gains tax indefinitely.
There is no limit on the number of 1031 exchanges you may make. However, if you get to a point where you want to cash out your profits, you’ll be required to pay any tax you owe. Because the laws around 1031 exchanges can be a little confusing, you may want to work with an experienced tax professional to help you navigate the rules.
#8: Opportunity zone investments
The US Treasury has created opportunity zones in low-income and disadvantaged areas of the country. The Tax Cuts and Jobs Act put provisions in place to encourage investors to put their money into developing these communities.
If you place your unrealized capital gains into a Qualified Opportunity Fund, you can get these tax advantages:
- Defer capital gains payments. Under the current law, you can defer paying the capital gains tax until 2026, or until you sell your stake in the Opportunity Fund.
- Increase your capital gains. If you hold your shares in the fund for five years, you can grow your capital gains by 10%, and the number increases to 15% if you hold your shares for seven years.
- Avoid paying capital gains on your investment earnings. If you keep your investment in a Qualified Opportunity Fund for 10 or more years, you can avoid paying any capital gains tax on the proceeds of your investment.
If you have the money to invest in an Opportunity Zone, it can be a way to help communities that need it while reaping significant tax benefits for yourself.
#9: Self-employed taxes
Anybody who is self-employed is required to pay FICA taxes, which cover Social Security taxes and Medicare taxes. Every self-employed individual must pay 15.3% of their income in payroll taxes, an amount that includes both the employer and employee contributions. You can avoid paying those taxes if you’re earning investment income from real estate.
For example, say you own a freelance graphic design business and earn $60,000 per year. You might be able to deduct expenses, but most of that $60,000 would be taxable income. However, income from rental properties you own would not be subject to the FICA tax.
Reap the benefits of real estate investing with help from Addition Financial
Real estate investments can provide both regular cash flow and long-term gains. The 9 tax benefits we’ve explained here will help you maximize your earnings while minimizing the amount of tax you’re required to pay.
Do you need a hand choosing real estate investments for your portfolio? Addition Financial is here to help! Click here to read about our MEMBERS Financial Services Program and make an appointment with a Financial Professional today.
Posted on Jul 13, 2023
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