You know diversifying your investments is a smart move. You’ve also heard that buying rental properties can produce a valuable cash flow. In addition, real estate investments have many tax advantages that reduce your yearly expenses and maximize your return on investment. Keep reading to learn about the tax benefits of real estate investing.
Tax Deductions
Real estate offers many opportunities to lower your tax liability. One of the biggest financial perks of this source of income is the tax deductions you can take. You can deduct expenses directly tied to the operation, management, and maintenance of the property, such as:
- Property taxes
- Property insurance
- Mortgage interest
- Property management fees
- Cost to maintain and repair the building
Many people don’t know that you can write off a lot of what you pay to run your investment. These expenses may include, but are not limited to:
- Advertising
- Office Space
- Business Equipment
- Legal and Accounting Fees
- Travel
These deductions lower your taxable income, which could save you money when you file your taxes. Make sure that you keep detailed, accurate records and receipts. This will help you prove the expenses you claimed if the IRS audits you.
Take Advantage of Capital Gains
A capital gains tax may be assessed when you sell an asset for a profit, like property. There are two types of capital gains: short-term and long-term.
Short-term capital gains
You realize a short-term capital gain when you profit from selling an asset within a year of owning it. While you may not have a choice but to sell, be aware that doing so can hurt your taxes. That’s because the gain gets counted as regular income.
So, if you earn $100,000 from your day job and sell an investment property for a $100,000 profit, your income essentially doubles for tax purposes. Unfortunately, if you file single, that extra income puts you in the next tax bracket (as of 2020), which potentially means a larger tax bill than you expected.
Long-term capital gains
On the other hand, you see a long-term capital gain if you profit from the sale of an asset that you’ve held for a year or longer. If you can wait until the anniversary of your purchase to sell, you’ll get to keep more money in your pocket. That’s because the long-term capital gains tax rate is significantly lower than the tax rate on income.
And, if your income is low enough, you may not have to pay the tax at all. For example, suppose you and your spouse make a combined $75,000 per year and file a joint tax return. The long-term capital gains tax rate for your income level is 0%. That means you can keep every cent of the profit you get when selling a property.
Depreciation
Many parts of your rental property will depreciate as it gets older. If you rent out real estate, depreciation allows you to write off any wear or tear that has occurred on your property each year. This applies to assets such as appliances, furniture, and even your roof.
You’re allowed to take the depreciation deduction for the entire expected life of a parcel (currently set by the IRS as 27.5 years for residential properties and 39 years for commercial properties). Once you sell, though, be prepared to pay the standard income tax rate on the depreciation you’ve claimed. This is known as depreciation recapture, which you can avoid if you pursue other tax strategies.
Passive Income
Real estate can also generate passive income. This means that while you hold a full-time job, your property is making money for you and providing tax deductions that reduce your taxable income. So when you invest in a rental property, you are not just diversifying your revenue streams but are also saving money.
Invest Tax-Free or Tax-Deferred
When you invest in real estate, it is possible to do so tax-free or tax-deferred. Tax-free means that there are no taxes applied when selling the property, and deferred means that you can delay paying taxes until later down the line. Tax-free or tax-deferred investments usually happen when you do a 1031 exchange.
A 1031 exchange involves selling an investment property you have owned for at least a year and buying real estate of equal or greater value within 180 days of selling your original parcel. In addition, both properties involved must be similar in use or nature for the transaction to qualify as a 1031 exchange.
Investing in real estate has a multitude of benefits. Not only is it a high payoff, but there are also tax advantages that come along with it. If you want to learn more about how owning real estate affects your taxes, contact Hayes & Associates. We’d love to give you more information.
