With home prices rising and the growing demand for rentals, real estate is a practical investment for many investors. Renter-occupied homes accounted for 30.4% of the housing inventory in the final quarter of 2020, according to the U.S. Census Bureau. Commercial real estate is an equally smart investment.
In addition to yielding great returns, there are many lesser-known benefits of investing in real estate, including:
Depreciation allows you to recoup the costs of maintaining income-producing properties or properties used for business purposes. The property’s loss in value is deducted over its expected lifespan, which is 39 years for commercial property and 27.5 years for residential property. Essentially, you’re deducting the value loss from normal wear and tear.
Let’s say that you purchased a single-family home for $220,000. Dividing that value by 27.5 years leaves you with $8,000 per year that you can deduct in depreciation.
Remember that depreciation can only be used on investment properties, so it’s a tax advantage exclusive to real estate investing.
Depreciation is beneficial in the short term. However, when you sell the property, you may need to pay standard income tax on the depreciation you claimed (known as depreciation recapture). There are ways to avoid depreciation recapture, such as a 1031 exchange.
Cost segregation is another strategy real estate investors can use to accelerate depreciation deductions and defer taxes.
Your accountant can help you determine the best strategy for handling depreciation recapture.
2. Expense Deductions
Another advantage of investing in real estate is being able to deduct expenses associated with the property, which may include:
- Property taxes and insurance
- Mortgage interest
- Management fees
- Advertising fees if you are renting or selling the property
- Maintenance, repairs, and renovations
Essentially, income-producing real estate is a business, and many of the expenses you incur for maintaining your properties can be deducted.
If you choose to invest in real estate through a limited partnership (LP) or a limited liability company (LLC), you can take advantage of other expenses you can deduct, such as:
- Legal fees
- Professional fees, including bookkeeper or accountant fees
- Office space
- Communication expenses, such as internet or phone lines
- Equipment, including laptops, phones, desks, etc.
- Membership fees for trade associations or professional organizations
- Education costs, such as seminars, books, courses, etc.
- Travel and meal expenses
These expenses can reduce your taxable income and lower your tax bill. Therefore, it’s important to keep accurate and detailed records of your expenses and to keep these records for at least seven years in case of an audit.
3. Capital Gains
If you sell a property for more than you originally paid for it, the profit is subject to either short-term or long-term capital gains. The tax rate for capital gains
is lower than standard income tax rates.
- Short-term capital gains apply to properties owned for less than a year. The tax rate can range from 10%-37%, depending on which income bracket you’re in.
- Long-term capital gains apply to properties owned for more than a year. Tax rates can range from 0% to 20%, depending on your income bracket.
Like with depreciation recapture, there are strategies you can use to defer or avoid capital gains taxes. A common one is a 1031 Exchange. Be sure to discuss this with your accountant beforehand so they can help you get the pieces and people necessary in place to execute before it’s too late – such as after you sell your property and are left with a bigger than the expected tax bill.
4. Pass-Through Deduction
If you own a rental property, either through an entity or as a sole proprietor, your rental income may be considered qualified business income, or QBI.
With a pass-through deduction, you can deduct up to 20% of your QBI on your personal taxes. So, if your rental properties generate $25,000 in rental income, you can deduct up to $5,000 on your personal tax return. It
Other types of income from real estate investments may also qualify. For example, if you invested in a crowdfunded real estate project, income distributions may also qualify for the pass-through deduction. REIT dividends may also qualify because they may be considered QBI.
If you have a QBI loss in any given year, that loss must be carried over to the next year. That loss could reduce your deductible QBI.
Of course, these are just simple examples, and there are other rules and regulations that need to be followed. For example, to claim the pass-through deduction, your rental activity must constitute a business for tax purposes, not an investment activity. Your accountant will walk you through the process.
5. 1031 Exchange
A 1031 Exchange allows you to exchange one investment property for another property that’s similar or greater in value. Other types of asset swaps are taxable at the sale, but with a 1031 Exchange, the tax liabilities are zero or minimal. Real estate investors can use this strategy to potentially avoid depreciation recapture or capital gains.
A 1031 Exchange can be used indefinitely, but when it comes time to cash in on your profits, you will need to pay any taxes that were deferred.
Like with other real estate tax strategies, it’s best to consult with your accountant about 1031 Exchanges.
6. Opportunity Zone Funds
To encourage growth in financially distressed and rural areas of the country, a tax incentive was rolled out with the Tax Cuts and Jobs Act. This incentive allows investors to put their qualified capital gains into what they call an “opportunity zone fund.”
There are more than 9,000 areas that have now been designated as opportunity zones.
Any money that goes into the fund will be put towards improving these zones.
An opportunity zone fund allows you to defer or eliminate your capital gains, depending on how long you hold onto your fund investment. If you remain invested in the fund for 10+ years, you can avoid paying capital gains entirely.
7. No FICA Taxes
When you’re self-employed, you’re responsible for paying the entire 15.3% tax for Social Security and Medicare (also known as self-employment tax or FICA taxes) on your income.
However, rental income is treated differently. If you are self-employed, your rental income is exempt from Medicare and Social Security taxes, saving you money on your taxes each year.
There are many tax benefits to investing in real estate. However, to take full advantage of these benefits, it’s important to consult with an experienced and qualified accountant.