Real Estate Investing Tax Strategies
Any investment, whether it be stocks, bonds, or collectible cars will have tax liabilities in one way or another.
Real estate is no different, and can pose its own challenges for both beginners and more experienced investors. But that doesn’t mean that you have to sit by and let taxes eat away at your profit margin.
In this article, we are going to be going over some great ways to decrease that tax bill so you can put more money either in your pocket or back into your investments. Here are some great real estate investing tax strategies.
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Primary Residence Tax Deductions
The first of the real estate investing tax strategies will be related to your primary residence. If you own your own home, you may have some tax deductions available to you.
Main Home Sale Gain Exclusion
If you've lived in your main home for 2 of the last 5 years, you may exclude $250,000 of gain if you’re filing single and $500,000 if you’re married. This is called the main home exclusion which excludes a portion of your gain on your primary residence.
You can take advantage of this exclusion if you make your new real estate purchase your primary residence for 2 years.
If you wanted to ,you could sit on your home for a few years and trade up to another home while paying no capital gains taxes on a sale. This is allowed as long as it is within the main home exclusion limitations.
Here's another real estate tax benefit. This is deductible as well if you itemize your deductions on schedule A. You may deduct up to the first $1 million in debt on your primary residence and a second home.
You may be able to deduct your real estate taxes paid on the real estate you own up to $10,000. Property and school taxes paid during the year is available as an itemized deduction on Schedule A.
Mortgage Insurance Premiums
Qualified mortgage insurance premiums are available as an itemized deduction as well if your adjusted gross income is below $109,000 for 2019.
The second real estate investing tax strategy we will take a look at is something called a 1031 like-kind exchange.
What this means is that you will be deferring your taxes by making use of your proceeds from selling real estate. You will then roll these proceeds into another real estate acquisition.
Using a 1031 exchange will allow you to defer capital gains taxes on the sale of an investment property.
To do this process, you must have a mediator who temporarily holds the funds in an account. Since you only have 180 days to roll the proceeds into another investment property and 45 days to identify the property, a 1031 exchange must be done with a carefully planned strategy.
You can make use of 1031 exchanges over and over again indefinitely to keep deferring the taxes on your profit. Obviously, this means you can’t spend the money on anything other than real estate. But you could always buy a rental property and earn passive income through rents.
The only way to win in the 1031 exchange tax-deferred game is to die. This sounds odd, but when you pass away any assets you leave behind will earn a stepped-up basis to the date of death value. Thus the deferred taxes will never be incurred.
Using Installment Sales
Using installment sales can be a unique real estate investing tax strategy.
Installment sales can increase your profit on a sale, but they can also carry more risk. What you’ll do is instead of selling the property outright in a single transaction, you’ll offer financing options for your buyer.
This allows you to charge the buyer interest, and you’ll only have to pay taxes on the principal and the down payment that the buyer will pay you in that year.
This means that you’ll be able to spread out the taxes over many years, instead of having to pay a bunch of income tax from a single lump sum. This allows you to avoid a possible jump in your marginal income tax bracket.
Like we stated previously, this does carry a bit of risk in that the buyer must pay you over a period of time.
You should be thoroughly vetting anyone that may be purchasing your property in order to avoid delinquent payments.
Real Estate Rental Property Tax Deductions
If you own a rental property there are unique real estate investing tax strategies available to you.
Just like any other time you are doing your taxes, you should be maximizing your deductions. Real estate comes with a few nifty kinds of deductions that you should be making use of to keep taxes low.
We talked about this a little bit above, but your mortgage interest is tax-deductible. This also applies to investment property loans and home equity lines of credit on your main home if used for improvements.
The local property taxes you pay will be fully deductible against your rental income. Unlike your main home, property taxes paid on your rental are not limited to $10,000. These taxes include school taxes, county taxes, city taxes and local property taxes.
Improvements are something that may increase the value of your property. This could be anything from adding more rooms to changing to energy-efficient windows or even some electrical work.
These are not instantaneously tax-deductible though and will be more applicable in the long term when you go to sell your home or property.
Capital improvements to rental properties must be depreciated over its useful life.
Repairs to an investment property can be tax-deductible. The IRS defines repairs as something that maintains your property, meaning it will keep it functioning and remain habitable.
While this is not unique to real estate investing ,it is still an important part of taxes each year.
You’ll be able to write off any expenses that you incur in order to maintain operations. For real estate, it can be anything from the trips you take to properties to maintaining your office.
Real Estate Depreciation
If you own a rental property, then you will be required to depreciate your property.
The IRS considers depreciation “allowed” or “allowable” meaning it is your choice whether you use depreciation on your taxes, but the IRS will act as though you did.
Basically, this works because the IRS gives your property a lifespan. It is 27.5 years for residential property and 39 years for commercial property.
The tax law states that you can write off the fraction of the investment that depreciates each year. An important note here is that land is not depreciated. Only assets with a useful life are depreciated. Since land typically does not lose value over time, it is excluded from the depreciation calculation.
It’s pretty helpful to see some actual numbers here so let’s go through an example:
You buy a residential property worth $175,000, and the land has a value of $25,000. This means you have $150,000 for the purposes of this deduction.
For the next 27.5 years, you’ll be able to write off 1/27.5 of your remaining value every year. In this case, the amount is $150,000 divided by 27.5 which comes to $5,454.
But when you go to sell, all prior depreciation taken on the property will be recaptured if your disposition results in a capital gain. You can learn more about depreciation recapture here.
Self-Directed IRAs For Real Estate Investing
You may be familiar with IRAs from your retirement accounts, but you can use them for different types of real estate investing tax strategies. Though there are a few hoops to jump through to get it to work.
This is not going to be as easy as setting up your IRA account for retirement. You have to find a company to create the self-directed IRA for you and you must have a custodian to take care of the account as well.
You will also need to form an entity such as an LLC to own the properties that you want to invest in. The IRA will then invest in the structured LLC.
This can get sticky very quickly if you don’t do a lot of research on how self-directed IRAs work. For instance, the custodian company is going to charge fees to manage this account for you.
And of course, you have the usual drawbacks of an IRA which means you will not be able to withdraw any money from it, without paying a penalty, until you are 59 1/2 years old.
Tax Cuts And Jobs Act: Qualified Business Income Deduction
The Tax Cuts and Jobs Act of 2017 made some substantial changes to the tax law. Along with the passage of the bill came some more opportunities for real estate investing tax strategies.
Something the new law included is the 20% Qualified Business Income tax deduction for specific types of businesses.
This made it possible for certain businesses to deduct an extra 20% of their net income. Keep in mind, 20% is a major amount for you to shave off of your taxable income when tax season rolls around.
Rental properties can qualify for the qualified business income deduction if they meet certain requirements. Check out the IRS guidelines to qualify under the safe harbor provision.
The IRS defines what qualifies as qualified business income. Make sure to do your research because certain types of businesses do have deduction limitations.
This deduction is available to a variety of different business entities this includes Sole proprietors, LLCs, and S-Corps. You should speak to an accountant about the best way to make use of these deductions for your business purposes.
Real estate investing is a great way to generate income and plan for the future. This makes real estate investing very enticing for would-be investors.
Real estate investing also comes with its own set of tax laws that you should be aware of. The strategies we have described are just a few of the ways to increase tax savings on your real estate investments.
Regardless, utilizing some of the tax strategies we covered in this article should give you a leg up when tax season rolls around this year. Be sure to do your research and consult a professional if you find yourself unsure about your real estate investing tax strategies.