The costs associated with becoming a real estate investor can be breathtaking. In addition to the purchasing costs, there are also repairs, maintenance, and a gauntlet of other fees that need to be considered. Luckily, we as investors can use these to our advantage thanks to the current tax laws. What tax benefits can real estate investors use? Let’s discuss.
Real estate investors can write off many legitimate expenses so long as they are associated with running your business. Things like cell phones, office supplies, and even the cost of gas can be written off as long as you can show that it’s an actual expense caused by running your business.
When you purchase a new property, you essentially start a new business (especially if you have an umbrella LLC). When an LLC owns a property with the intent to generate income from it, that opens up a bunch of tax advantages.
However, it’s not all sunshine and rainbows. While there are tax benefits, there are also significant income taxes that come into play. The profits of any real estate sale can be susceptible to capital gains tax which can knock new investors for a loop.
But there is a way to avoid the dreaded capital gains tax and possibly even move you into a lower tax bracket. Let’s dive in.
Please Always Check with Your CPA
While we at The Investor's Edge are experts at real estate investing, we’re not experts in your specific tax situation and are not financial advisors. Check with your CPA to understand the requirements your city and state have and the federal government. There may be local tax laws that allow for certain tax benefits for your specific needs, so don’t skimp on getting a professional to walk you through this.
Tax Benefits for Real Estate Investors: Depreciation!
I love depreciation. In my opinion, it’s the best tax benefit for the type of businesses we run as real estate investors.
Why is depreciation so significant? Well, it’s pretty much common sense to realize that as you hold a property over time, things will inevitably break down. Whether you’re working with rental properties or are doing fix & flips, there are ongoing upkeep costs that will come with your business. The walls will need to be repainted, the carpet will need to be replaced, the furnace might give out. These are all actual costs that should be expected for any investor.
The good thing about all of those costs is that they’re considered depreciation and can help lower your overall taxable income. When you reduce your taxable income, you may be able to knock yourself down to the lower tax bracket than what you would have been initially required to pay.
Because of this, you may be able to get double the benefits. Moving into a lower tax bracket will save you money by reducing not only the percentage of tax you’d be liable for but the actual cash you’d be obligated to pay. There’s some nuance here, so if that sounds confusing, talk to your CPA about your options.
There are two methods that you can use: a standard depreciation schedule or accelerated depreciation schedule. Most of the time, I prefer the accelerated schedule.
Here’s how it works: To get put into an accelerated depreciation schedule, you’ll need to hire a professional to tour your property. They’ll then arrange a cost list of everything on the property. From this list, they’ll create an accelerated depreciation list that will allow you to get the bulk of your tax benefits now rather than spacing them out over time.
Depreciation Is Not Permanent
Your tax liability for depreciation doesn’t end there. If you decide to sell the property with an accelerated depreciation schedule, you’ll be liable for what’s known as depreciation recapture. All of the deductions you’ve been taking because of depreciation will come back to haunt you when it’s time to pay your taxes.
Also, you may be required to pay the dreaded capital gains tax. Capital gains taxes are required to be paid for any profits made from investments like real estate or stocks. The general rule of thumb is to lower your capital gains taxes by planning a long-term investment strategy. If you’re able to hold on to your property for more than a year, you’ll most likely be subjected to long-term capital gains rules rather than short-term. Short-term capital gains are much more substantial than long-term, so it’s in your interest to plan for a strategy where you hold onto a property for at least a full year.
1031 Exchange: a Legal Loophole to Avoid Capital Gains
However, there is a way to defer your tax obligations on the profits you’ve made from selling a property, including short-term capital gains. That deferment loophole is known as the 1031 exchange.
To be eligible for a 1031 exchange, you’ll need to take any profits made from the sale of a property and roll those over into purchasing a new property. Now, there are some rules around being eligible for this. It gets a little complicated because you’ll need to roll profits into a “like-for-like” style property and are accountable to specific cut-off times for identifying those properties.
The bad news is that “like-for-like” can have some stringent requirements that can make it challenging to qualify for 1031. The good news is that there are professionals that specialize in this who can help you figure this out.
How to Move from “Deferred” to “Completely Avoided” Tax Obligations
Qualifying for a 1031 exchange doesn’t mean you’re permanently free from paying taxes on your profits; it just means they’ll be deferred. However, there is one way to avoid paying capital gains altogether.
As long as the property is part of your business, the tax is deferred. So if you never sell the property, you can avoid the tax obligation altogether.
That doesn’t mean you’re free from any tax whatsoever. You will still have to pay tax on income the property generates (like rental fees), but you can avoid the capital gains tax, which will save you a ton of money.
A Tip for if You’re Just Getting Started
If you’re just starting as a real estate investor, I’d recommend taking it slow and starting small. Don’t try to flip your first property and immediately go for a 1031 exchange, as you can make some serious errors that can end up being very costly.
Instead, consult your CPA to see which expenses qualify as write-offs and go from there. That way, you’ll become educated on the tax benefits you’re eligible to receive and build on that knowledge to reach better options.
The tax benefits available to real estate investors are why so many of the wealthy hold onto real estate properties as a way to create tax havens for their money. Those properties will also generate more income opportunities, which generates more cash flow and helps maintain their position in the upper class.
But that doesn’t mean you can’t use those same tax benefits, too. Study these tips and let us know in the comments if you have used any of them to help create a profitable business.
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