Let’s talk about taxes and their benefits! This article is going to be based on my own knowledge and research on tax advantages in real estate, however, always consult a tax professional to ensure you are filing your taxes and using tax strategies appropriately. Ok, so why is real estate such a tax friendly investment? Let’s check it out…
What is depreciation? Depreciation is going to help us keep more of our money each year when tax season rolls around. Depreciation is simply the reduction in the value of an asset over time due to wear and tear. In the minds of the IRS, they believe that this wear and tear occurs over 27.5 years and then the house would basically be completely ruined or “used up” as an asset.
However this doesn’t actually happen of course. Homes that are kept up nicely and even some that are not, appreciate in value over time. In real estate the value almost never ever goes to 0. In order to use depreciation, you will take the value of the improvements on a residential property. This is excluding the land because land doesn’t wear out. Then divide it by 27.5 years. Then, that number you get will be “deducted” from your taxable income. This is going to offset your tax liability so you will then pay taxes on the lower taxable income number.
Accelerated Depreciation & Cost Segregation Studies
Next, the crazy motorcycle riding cousin to depreciation, we have accelerated depreciation, which we can use by doing cost segregation studies. This is advanced stuff so you may not want to use this if you’re a beginner, but essentially, cost segregation studies are going to let you depreciate certain parts of your property such as a hot water heater, flooring, or other elements, faster than the normal rate. You must hire a tax accountant or cost segregation specialist to help you do a cost segregation study as you’re not allowed to do it yourself. These accountants are usually pretty expensive, so it’s best to do some math on whether or not the cost of the accountant will really be saving you money through accelerated depreciation or if you’re just going to be a break even or worse.
You may or may not realize it, but doing a refinance is actually a great tax advantage of real estate. When you refinance a home, you are getting a new loan to pay off the previous loan, often to lower your interest rate or get a more favorable term for your needs, but you may also be conducting a cash-out refinance. In this case, you are tapping into the equity in your property and gaining the ability to use that cash however you’d like, hopefully, buying more real estate.
When conducting a cash-out refinance, it’s considered a new loan paying off a prior loan, and not income, so the cash is not taxed and does not trigger a taxable event in the eyes of the IRS. What a beautiful thing! In most other asset classes, you’d usually have to sell the asset to derive any cash from it. In the case of a cash-out refinance, you can tap into the cash, and still control the asset.
The 1031 Exchange
For the 1031 exchange, I am going to refer you to my good friend Sam from 2020, when he made a video about this very topic! Check out my video on The 1031 Exchange. Basically, the 1031 exchange is a tax free way to trade one property for another and skip out on that pesky tax liability or at least defer it for when you want to pay it! Watch the 1031 video for a deep dive on how all that works!
Investing Through a Self-Directed Retirement Account
What is a self-directed IRA? A self-directed IRA is a tax protected savings account. Then, inside that savings account, we are able to buy and control assets. We can invest in all kinds of assets with a few limitations, but real estate is totally allowed!
So, to take advantage of this tax benefit, you’ll need to open a self-directed IRA, fund it with cash, and then buy real estate inside of that account. Then, all the returns you make from rents go back into that account. Just make sure you follow all the rules of self-directed IRAs, you can get in trouble if you’re not careful.
The best part about investing in real estate using a self-directed IRA is that on the Roth option for a self-directed IRA, where you contribute post-tax dollars into it, you won’t pay taxes on any of the appreciation or any of the rental income from your properties if you keep the returns in the account until retirement age. Let me be clear, you could legally never pay taxes on ANY of the appreciation or rent that is collected from the property your entire life. Basically, your tenant is paying into your retirement plan for you, and it’s tax free! Now that’s a life-hack.
The Capital Gains Exemption
This is a really cool tax benefits of investing in real estate that almost anyone can see benefits from. This benefit is for investors who live in the property for 2 out of the last 5 years as a primary residence and allows a single person to sell their house with up to $250,000 in profits, or if a couple, $500,000 in profits, and pay no taxes on those gains. This won’t work well for house flippers who hold a property for less than 2 years, but it will work well for house HACKERS; those investors that live in a primary residence and rent out the extra space. Live in it for 2 years, do a renovation to add value or just let it appreciate, and boom, you qualify for the capital gains exemption. Tax free growth! Now can you see how the government really wants people to buy houses?
This is the fun part of real estate if you hate paying taxes! We just mentioned a type of deduction earlier actually – depreciation! Deductions are usually anything that produces a loss on paper for your property. When we take these deductions, they help reduce our tax burden.
All of the following are examples of deductions you can take on an investment property: mortgage interest, property taxes, expenses/repairs, management fees, business related expenses relating to managing the property, depreciation, lost rents. If operating as a business, you can also write off vehicles, gas/miles, accounting, legal, materials, and equipment such as computers and phones. Can you see how low we might be able to make our tax burden? Maybe even get it down to zero!
Tax Basis Reset at Death
A final benefit of investing in real estate is one to consider when thinking about legacy. What will you do with all your real estate in your later years? Will you sell it all or pass it on to your heirs? If you pass it on, the cost basis for the properties you own will be stepped up at your death. Explained more simply, if you sold your properties before your death, you would have to pay tax on the appreciation of those properties. However, if you pass them along, the cost basis becomes the current value of the properties. If your child, for instance, wanted to sell the property after taking possession of it, they could with no capital gains tax due. This could repeat generation after generation so that your family could build tax free wealth over generations and generations.
Opportunity zones are an economic development tool that incentivises investors to invest in distressed areas throughout the US. These distressed areas are usually low income and undercapitalized.
So what are the tax advantages of opportunity zones?
- Opportunity zones give a temporary deferral of taxes on previously earned capital gains
- Digging into that, investors can place existing assets with accumulated capital gains into opportunity funds. (the investment vehicle that invests in opportunity zones). This includes ANY capital gains on ANY assets sold within the last 180 days. They could be stocks, bonds, house flips, etc. As long as you put that new capital into an opportunity fund.
- Opportunity zones give a tax basis step-up of previously earned capital gains that are invested.
- For capital gains placed in opportunity funds for at least 5 years, investors’ basis on the original investment increases by 10 percent. If invested for at least 7 years, investors’ basis on the original investment increases by 15 percent. This is basically a discount on the amount of tax you will have to pay when the tax bill finally comes due.
- Opportunity zones offer no capital gains tax on new gains.
- For investments held for at least 10 years, investors pay no taxes on any capital gains produced through their investment in opportunity funds.
Where are opportunity zones? There are a lot! Here is a map put out by the Department of Housing and Urban Development.
Real Estate & The IRS
There are three main ways that the IRS officially views all real estate investors: you can be a passive investor, active investor, or real estate professional.
As a passive investor, you don’t really participate in your investments at all, you can only deduct passive losses against passive gains. Aka you can only deduct a loss like depreciation from your rental income. That’s pretty limiting. As an active investor, you can deduct up to $25,000 of passive losses from ordinary or earned income, but this extra benefit starts to phase out as you get close to $150,000/yr in income and then completely goes away above that. Meaning, you wouldn’t be able to use any of your losses to your advantage if you made over $150,000/yr. To qualify as an active investor, all you have to do is be involved in making decisions about the property, a little more than a passive investor if you will.
Real Estate Professional Status
Lastly, you can be categorized as a real estate professional which allows you to deduct 100% of your real estate losses against earned income. This means no matter how much money you make at your W-2 job, you’ll be able to deduct losses on your properties from it and with no income cap.
To qualify as a real estate professional, a taxpayer must pass a two-part test:
(1) the taxpayer must spend the majority of his or her time in real property businesses
- So this means you’ll need to work in some sort of real estate business full time
(2) the taxpayer must spend 750 hours or more in the real property business and rentals in which he or she materially participates
- It is best practice to keep a time log of all services performed so you’ll have verification for this requirement
By becoming a real estate professional or at the very least an active investor, you’ll get the most bang for your buck when it comes to the tax advantages of investing in real estate.
Invest for Fundamentals
Remember, don’t invest in real estate just for the tax benefits, we need to focus on investing fundamentals and look at our returns. If only tax benefits are keeping your property afloat, you may be taking on too much risk. Invest for fundamentals and don’t get out over your skis.
However, if you’re investing in real estate and paying a lot of taxes, you’re probably doing something wrong! Just remember, the tax code was written by landlords! They just want you to educate yourself and find out the secret easter eggs they left for you! In contrast, the current tax system may not be around forever and tax benefits can come and go, depending on the government, so stay up to date with real estate tax law and always consult a tax professional.
If you need help with taxes or want to learn more, join us here at Rent to Retirement so you can enjoy the benefits from our trusted network of real estate tax professionals and CPAs. Sign up for a call with one of our investment counselors and we’ll get you to the right place.