The road to purchasing your first home may be long, and even when you do reach that milestone, many first-time homeowners are often surprised by all the taxes. You might think that the more property you own, the more you pay in taxes, but the truth of the matter is, real estate investing is a lucrative business and savvy investors can pay less than you’d imagine come tax time. Here’s why – and how you can benefit too.
Real estate tax deductions
Businesses benefit from major tax write-offs, and a real estate business is no exception. Legally speaking, real estate investors can deduct a host of expenses tied directly to the operation of the business, including:
- Property taxes
- Property insurance
- Mortgage interest
- Property management fees
- Property maintenance and repair costs
On top of operating expenses, businesses can also deduct qualified business expenses, further lowering their taxable income. Some such expenses are:
- Advertising costs
- Office space
- Business equipment
- Legal and accounting fees
- Qualified travel
All these deductions add up. For example, if you earned $20,000 from a rental property and deduct $8,000 in qualified expenses, your taxable business income drops to a mere $12,000.
Depreciation
Real estate investments can benefit from an additional deduction: depreciation. Depreciation is discounting the deterioration, wear and tear and loss of value over time. Real estate investors holding income-producing properties can deduct depreciation on those properties as an expense.
Investors generally use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS), in which residential rental property and structural improvements are depreciated over 27.5 years and appliance/fixture upgrades are depreciated over 15 years. Commercial properties are allowed 39 years by the IRS.
For instance, let’s say you bought a rental property and the value of the building is $300,000. Calculating general depreciation, you’d divide $300,000 by 27.5 years, equating to $10,909.09 in deductible depreciation the first year. Depending on if you use a declining-balance or straight-line method, the subsequent depreciation may change.
When selling, though, depreciation may be recaptured through higher taxation. In this case, the amount depreciated may be taxed as high as 25%, with the non-recapture amount taxed at the prevailing capital gains rate.
Importantly, depreciation expense often results in a net loss on investment properties – even if the property actually produces a positive cash flow.
Taking advantage of capital gains
A capital gains tax may be assessed if you sell a property for a profit. Real estate investors seek to minimize this tax on their profits and capitalize on timing to do so.
Short-term capital gains applies to assets owned for less than a year. These assets are taxed as ordinary income, i.e. at your personal income tax rate.
On the other hand, long-term capital gains applies to assets owned for a year or more. For 2022, long-term capital gains are taxed at 0%, 15% and 20% depending on the tax bracket. These rates are often lower than an individual’s personal tax rate.
However, it’s important to note that deducting depreciation can result in a higher tax bill when it comes time to sell. That’s because depreciation essentially reduces the amount you’re considered to have paid for the property when you acquire it. For instance, if you bought a property for $100,000 and deducted $5,000 in depreciation, for tax purposes your property was worth $95,000 at purchase. So if you sell it for $200,000 after a year, your gains are not $100,000 ($200,000 – $100,000) but $105,000 ($200,000 – $95,000).
Many real estate investors can avoid paying these taxes, as well as depreciation recapture, by benefiting from the following benefit, a 1030 exchange.
Benefiting from a 1030 exchange
The 1030 exchange, named for Section 1030 of the Internal Revenue Code, allows investors to defer taxes by selling an investment property and then using those proceeds to buy another like-kind property of equal or greater value. If you continually reinvested the profits in another investment property, you could theoretically never pay a cent in capital gains. Only when an investor wants to cash out will taxes be due. To qualify, an investor must use a qualified intermediary and meet specific timing deadlines.
Personal tax pass-through deduction
Another newer tax benefit for real estate businesses comes in the form of a pass-through deduction. Under the Tax Cuts and Jobs Act of 2017, tax law allows owners to deduct 20% of their net qualified business income (QBI) on personal tax returns. Whether you own the property as a sole proprietor, partnership, LLC or corporation, the rent you collect is considered qualified business income and is therefore fair game.
Depending on your situation, however, you may need to consult an accountant or tax attorney to understand the exact ins and outs of your individual tax requirements.
Note: Pass-through deductions are set to expire in 2025 unless renewed by Congress.
Legally avoiding the FICA tax
Lastly, since rental income is considered qualified business income for tax purposes, real estate investors do not have to pay Social Security and Medicare (FICA) taxes like self-employed individuals.
Remember how launching a business forms one of the Pillars of Building Wealth? Self-employed earners have to pay both the employee and employer’s portion of FICA taxes on earned income, to the tune of 15.3%. Businesses do not.
How individual homeowners can lower their taxes
All that said, you might be wondering how an average homeowner can benefit from some tax breaks, too. In fact, homeownership offers several perks that renting does not, and the ability to lower taxes owed is one of them.
Individuals can also take certain deductions, just like real estate investors. This includes the option to deduct mortgage interest from your personal tax returns. According to the IRS, you can deduct home mortgage interest on the first $750,000 of your home loan ($375,000 if married filing separately). If your loan was incurred before Decemeber 2017, higher limits apply ($1 million and $500,000 respectively). In other words, you can deduct the portion of your mortgage attributable to interest and therefore lower your taxes.
Homeowners can also defer paying capital gains taxes. Gains from the sale of a taxpayer’s primary residence are excluded from capital gains taxation up to $500,000 for married couples filing jointly and $250,000 for single individuals. The only requirement is that the taxpayer has lived in the home for two of the last five years. Additionally, if the gains from the sale of that primary residence are greater than the exclusion amount, the taxpayer is allowed to invest the excess through a 1030 exchange (usually only allowed when selling one investment property for another). This allows individuals to trade up their homes, building their personal wealth and minimizing taxes at the same time.
Bottom line
There are many advantages to real estate investing, and the ability to lower taxes is a major draw. Through a combination of deductions and tax-deferral strategies, real estate investors can even claim legitimate losses and not pay a cent in income taxes on their properties. Homeowners can also benefit from abbreviated versions of these tax breaks by deducting mortgage interest and deferring capital gains taxes.
