Tax Benefits Of Real Estate Investing: What To Know

The tax benefits of real estate investing can be significant and impactful. In fact, tax deductions are one reason people often start investing in real estate. Real estate investors enjoy making new investments in single-family residences, multifamily housing and other types of property, knowing that they’ll reap important tax benefits. If you’re thinking ofadding a rental property to your portfolio, it pays to understand how these investments might impact your income taxes.

Are There Tax Benefits To Real Estate Investing?

With real estate investing, buying a house or multifamily investment property can provide you with all sorts of tax-saving upsides that include benefits far beyond growing equity or collecting rent. Here are six notable tax benefits to be aware of and consider.

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. This means that you won’t have to worry about paying taxes on these expenses.

In fact, some aspiring real estate investors even use the process of house hacking to compound deductible benefits, as homeowners can enjoy access to additional tax write-offs when they invest with their primary residence. Just a few of many common tax-deductible expenses you can potentially tap into as part of real estate investing depending on your property ownership and business dealings include:

• Mortgage interest
• Property taxes
• Property insurance
• Property management fees
• Building maintenance and repairs
• Qualified business expenses

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 

The practice of depreciation helps account for wear, tear and degradation that occur on a property over time. In effect, it provides a means for helping real estate investors take tax deductions on rental properties, which inevitably suffer negative effects of usage over a prolonged period of years.

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.

To calculate property depreciation, 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. In essence, when you apply depreciation to a property, it lowers your cost basis in 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.

Let’s say you purchase a new property for $250,000 and then apply $50,000 in depreciation, causing your cost basis to be reduced to $200,000. If you sold the property for $300,000 at a later date, the IRS would calculate your capital gains tax using a profit margin of $100,000 instead of $50,000.

3. Passive Income And Pass-Through Deduction

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

Per the QBI, those who qualify 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). A good example of this is qualified rental income. The Internal Revenue Service (IRS) often classifies real estate income received in such a fashion as passive income, even though it can take considerable work to bring in tenants and rental money on a recurring basis.

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

4. Capital Gains Tax

If you’re involved or thinking of getting 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:

• Single-family homes
• Multifamily residences
• Apartments
• Condo buildings

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. 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 because they’re treated as general income and taxed at your marginal tax rate (aka according to your current tax bracket). If more than a year passes before you sell the asset and recognize these gains, though, the IRS would view any profits as long-term capital gains instead.

Long-Term Capital Gains

Long-term capital gains speak to profits recognized from assets you’ve held for more than one year. Earnings realized as long-term capital gains are taxed at a lower tax rate than those derived from short-term capital gains, generally being billed at a rate of 15% – 20% versus marginal tax rates. Therefore, it generally pays to hold onto investments a little longer as a result of these savings opportunities.

5. Incentive Programs

Real estate investors, depending on how they structure their property ownership and portfolio of holdings, may also be eligible to capitalize on various tax incentive programs. These programs allow you to recognize added tax savings on qualifying investments and income, but eligibility is limited.

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 peopleand 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 attached requirements that vary by account. Before applying, you’ll want to consult a qualified financial professional to determine to what extent, if any, these accounts can help you lower your tax burden.

6. Self-Employment FICA Tax

Per the Federal Insurance Contributions Act (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 not subject to self-employment taxation, certain types of rental activities may trigger self-employment taxes, which are important to be aware of as a real estate investor.

The Bottom Line

Current or aspiring real estate investors can enjoy many potential tax benefits of investing in real estate. Whetheryou’re looking to pick up a single rental property or build out an entire portfolio of multifamily or multiunit buildings, you may be surprised at just how many tax deductions you stand to reap.

Because of these many upsides, it pays to think strategically when structuring investments, and it’s also important tothink about how prospective tax breaks can play into your financial planning.

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