The Tax Benefits of Investing in Real Estate
- Last updated on . Written by Offshore Protection.
People often get dissuaded from investing in real estate because of the high cost involved.
They may think that it is not worth paying so much money for something they are going to be taxed on anyways, but what if I told you there was a loophole?
In this article, we will talk about a few ways to invest in real estate and at the same time save on taxes.
Table of Contents:
- Why Invest in Real Estate
- Deducting Expenses
- 1031 Exchange
- Pass-Through Tax Deduction for Passive Income
- Capital Gains
- Tax-Free Retirement Accounts
- Opportunity Zones
Why Invest in Real Estate
People typically don't see any tax benefits when purchasing property due to how expensive and time-consuming it can be. In the current economic climate, there are several different benefits to investing in real estate.
When you have a thorough understanding of the laws and loopholes that apply, it can be an extremely lucrative investment as real estate is an asset class that despite having possible short-term fluctuations, as a long-term asset you can almost always be assured to get returns. In addition to the ROI, real estate it is also possible to avoid paying taxes altogether.
If you are planning on buying real estate to rent it out, then it n considered a business. As a business, there are a number of deductions you can make. The most common are
- Property taxes
- Mortgage interest
- Property interest
- Property management fees
- Cost of maintaining the property.
Other deductions you are likely able to get are on things like advertising, equipment, legal and accounting fees, travel, and even office space. Being an investor, you can also deduct a mortgage on the primary or secondary residence which applies to both home purchases and equity loans.
There are plenty of ways to get deductions, you just have to be creative in order to leverage these deductions. Make sure to keep a record of all the expenditures made through the years so that you are able to make the most of any tax deductions that you can. Let's talk about some of these possibilities.
When your income is dependent on your rental property, the condition of the property can have a significant impact on your income. For instance, if the house falls in disrepair you are likely not able to get as much rent and likely would to get a tax reduction.
This way you can recover any of your costs through an annual tax deduction. What’s great about this opportunity is that you can take the depreciation deduction for as long as the property is considered viable. For residential buildings, it is 27.5 years and for commercial buildings, it is 39 years. You will find you can save quite a bit of money each year this way.
This tax deduction will be an allowance for wear and tear, but the amount of depreciation will greatly depend on the value of property, recovery period, and depreciation method applied on the property according to the real estate legislation in that state.
However, the depreciation deduction is only viable if you want to keep the real estate property for a long time. If you decide to sell it, you need to reclaim the depreciation cost and pay taxes. In case you want to invest in real estate now so that you can make use of this opportunity, later on, you should consider buying a house or commercial building.
Although depreciation is a smart way to save money each year, it is not a permanent solution since all the depreciation costs have to be submitted when selling. Section 1031 of the Internal Revenue Code or what is called a 1030 Exchange is where one real estate investment asset is swapped for another.
Although investment swaps are taxable events, using 1031 will allow you to forgo your tax obligations until you decide to sell it as its lasts for the entire tax year. To qualify for a 1031 exchange, investment properties must meet the following criteria:
- The value of the replacement property must be equal or greater than that of the resigned property
- Properties that are being exchanged in the transaction must be exchanged for some type of asset, such as a real estate investment trust (REIT)
- The exchanging of properties must be held for “productive reasons in business.”
Pass-Through Tax Deduction for Passive Income
Passive income refers to any income in which you don’t physically participate. In regard to real estate, it is income generated from renting out property. According to the Tax Cuts and Job Act that was passed in 2018, if you set up real estate investment as a business opportunity and conduct it as any small business, then you could be given a pass-through deduction of 20%.
In order to qualify the business conducted on the property must be profitable and earn qualified business income (QBI). In order to be eligible for this deduction, it is imperative that you speak with a lawyer and accountant before making any decisions. They will guide you through the process of claiming your deductions so that they are done in accordance with federal tax code regulations.
Real estate investments have the capacity to make huge capital gains. When any piece of real estate is sold taxes are levied on all profits obtained by its sale. Having a capital gain tax on your property which is normally less than income tax.
Capital gain exclusion can be used more than once and it allows homeowners to be exempt from paying taxes on profits up to $500,000. Even if the capital losses exceed capital gains, the investors will be allowed to offset upwards of $3,000 of other income.
Tax-free retirement accounts
Savings accounts like individual retirement accounts (IRA) or Self Directed IRA allow you the ability to invest in different asset classes tax-free. The type of account, the specifications, and the number of assets held will all determine what your tax-saving status would be. Because there are many different types of accounts be sure you investigate before opening, as not all accounts are created equal.
For those looking for a more creative way to invest The Tax Cuts and Jobs Act created 8,700 designated census tracts as "Opportunity Zones." These zones are home to distressed rural areas that need growth stimulation. Investors that decide to put some assets into these spaces can defer capital gains and pay no tax on their investment for a given period of time.
With the tax benefits you can enjoy when investing in real estate, it's no wonder that so many are looking to get involved. With these additional tax breaks available for investors and business owners alike, investing in real estate is something to explore.