Tax Benefits Of Real Estate Investing: What To Know

8 Min Read
Updated Jan. 7, 2024
Written By
Scott Steinberg
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Thinking of adding a rental property to your portfolio? If so, it pays to understand how these investments might impact your income taxes. There are real estate tax benefits for beginner real estate investors, those renting extra units in multi-family homes or people leasing their second home.

If you’re looking to start investing in real estate, but aren’t quite sure what the tax benefits are, we’ve got you covered. We’ll go over some of the most common income tax deductions and other important rules that could influence your tax bill while investing in real estate.

Are There Tax Benefits To Real Estate Investing?

With real estate investing, buying a house or a multifamily investment property can provide you with all sorts of tax-saving upsides. The main advantages of investing in real estate are growing your equity in a property and the income stream from rentals, but you can also save quite a bit when tax season comes around. There are six notable tax benefits to consider.

See What You Qualify For

The Top 6 Investment Property Tax Benefits

Top tax benefits to be enjoyed from real estate investing include but are not limited to, the following:

1. Deductible Expenses

Many common costs incurred by real estate investors qualify as deductible expenses that you can claim on your taxes. If you rent out part of your primary residence you may also qualify for some of the tax write-offs investors benefit from.

Depending on your property ownership and business dealings, some of the deductions you might qualify for include:

If you have questions about which expenses may be tax-deductible, you can always ask a qualified tax professional. You may be surprised at just how much money you may be entitled to write off.

2. Depreciation Deduction

The practice of rental property depreciation helps account for wear and tear on a property over time. This deduction helps real estate investors account for the inevitable negative effects of utilization from prolonged usage by tenants.

Depreciation is determined by calculating the useful time frame (aka useful life) of the property and applying a formula to compute how much value is lost each year. Once done, you can claim the annual deduction on your taxes, helping lower your taxable income.

Calculating The Depreciation Deduction

To calculate property depreciation, you start by determining your cost basis in the property, dividing it by the property’s useful life and computing a depreciation schedule. Once you’ve calculated this schedule, you can use it to compute and secure annual tax deductions.

When selling your property, be aware of a practice known as depreciation recapture. Though the depreciation deduction can lower your yearly tax bill, it also lowers the total cost of owning your property. This is what’s referred to as your cost basis.

When you apply depreciation to a property, it lowers your cost basis for the investment holding. At the time you sell the property, the IRS will calculate capital gains tax based on a profit margin that reflects this new cost basis − an example of depreciation recapture at work.

Depreciation Deduction Example

Let’s say you purchase a new property for $250,000 and then apply $50,000 in depreciation. This causes your cost basis to be reduced to $200,000.

If you then sell the property for $300,000, the IRS will calculate your capital gains tax using a profit margin of $100,000 instead of $50,000.

If you aren’t sure if taking the depreciation deduction is right for you, check with an accountant or tax professional to explore the pros and cons.

3. Passive Income And Pass-Through Deduction

The Tax Cuts and Jobs Act of 2017 created a helpful tax deduction for real estate investors, small business owners and self-employed professionals. This deduction is called the qualified business income (QBI) deduction, or pass-through tax deduction.

If you qualify for QBI you can receive up to a 20% deduction on income received from pass-through business entities such as partnerships, sole proprietorships, S-corporations and limited liability companies (LLCs).

One good example that qualifies is rental income. The Internal Revenue Service (IRS) often classifies real estate income as passive income – even though it can take considerable work to advertise, find tenants and maintain a rental property.

Depending on the type of property you own and how it operates, you may be eligible for QBI and more tax-saving benefits and deductions.

4. Capital Gains Tax

If you’re involved in the world of real estate investment, you’ve probably heard of capital gains tax. Essentially, whenever you sell an asset that grows in value, you may be required to pay taxes on the profits gained from that investment. This includes properties such as:

Capital gains tax is generally applied to appreciation on your investments, but it can vary depending on how much you earn, how long you’ve owned the asset and your tax filing status.

For example, if your taxable income is under certain present thresholds, capital gains tax may range from 0% – 15% or jump to 20% if your taxable income exceeds these thresholds. It also depends on how long you’ve held the assets.

If you’re looking for a way to save on capital gains in your taxes, timing can be everything. Here’s a breakdown of the difference between short- and long-term capital gains:

Short-Term Capital Gains

Short-term capital gains are profits you’ve earned on assets you’ve had in your portfolio of investment holdings for 12 months or less. These capital gains can have a negative impact on your taxes. This is because they’re treated as general income and taxed at your marginal tax rate (your current tax bracket). If more than a year passes before you sell and recognize these gains, the IRS sees any profit as long-term capital gains instead.

Long-Term Capital Gains

Long-term capital gains are profits from assets you held for more than one year. Earnings that qualify as long-term capital gains are taxed at a lower tax rate compared to income from short-term capital gains.

Long-term capital gains are generally being taxed at a rate of 0%, 15% or 20% versus being taxed as income according to your tax bracket. Therefore, it generally pays to hold onto investments a little longer to take advantage of the tax break for long-term capital gains.

5. Incentive Programs

Real estate investors may also be eligible to capitalize on various tax incentive programs. If you’re eligible, these programs create tax savings or defer taxes on qualifying investments and income:

1031 Exchange

The 1031 exchange allows you to sell one business or investment property and purchase another without subjecting yourself to capital gains taxes. However, the exchange must be completed and conducted per IRS rules. Your new property must be of the same nature as the original, and of equal or greater value than the property sold.

A 1031 exchange effectively allows you to swap out a real estate investment in place of another and defer taxes on capital gains. Note that using a 1031 exchange only lets you put off payment to a later date − not reduce your tax bill or avoid paying taxes entirely.

Opportunity Zones

Created via the Tax Cuts and Jobs Act of 2017, opportunity zones are a way the government encourages people and businesses to invest in certain communities to promote economic growth.

These geographic regions have been identified as low-income census areas and targeted for job growth and economic stimulus. Real estate investors can capitalize on opportunity zones by rolling qualified capital gains into an opportunity zone fund within 180 days of the sale of an asset.

Tax-Free Or Tax-Deferred Retirement Accounts

Select tax-free and tax-deferred retirement accounts, such as some 401(k) plans and Roth IRAs, may provide opportunities for you to invest in alternative assets beyond stocks and bonds. These opportunities can include private or commercial real estate, real estate investment trusts (REITs) and other property-based holdings.

However, tax-deferred and tax-free retirement accounts often come with savings contribution limits and requirements can vary by account. Before applying, you’ll want to consult a qualified financial professional to determine if these accounts can help you lower your tax burden.

6. Self-Employment FICA Tax

Under the Federal Insurance Contributions Act, or FICA, self-employed people are responsible for 15.3% of Social Security and Medicare income taxes. However, while rental income is taxable to some extent under standard income guidelines, it isn’t subject to FICA taxes.

Filing a Schedule E tax form makes the IRS aware of how much rental income you’ve earned and how taxes should be applied here. While schedule E income is generally exempt from FICA taxes, some rental activities could change this status.

It is recommended that you consult a certified and vetted tax professional to ensure that everything is correct and legal before proceeding.

The Bottom Line

Current or aspiring real estate investors can enjoy many potential tax benefits. Whether you’re looking to pick up a single rental property – or build out an entire portfolio of multifamily or multi-unit buildings – you may be surprised at just how many tax benefits you might be eligible for.

Thinking strategically when structuring investments can help you maximize your profits and real estate tax benefits. Planning how to implement prospective tax breaks can help save you money, especially if you invest in long-term financial planning.

Ready to start investing in real estate? Make sure you’re ready to make a competitive offer and today.

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