Real Estate Tax Advantages And Deductions
As investors, we take many considerations into account before we commit capital to an investment. A very important factor when analyzing an investment is the tax law surrounding that specific decision. Real estate investors can use a variety of tax deductions and exemptions to their benefit.
Real estate investing has many laws, and when used effectively, you can use these laws to your benefit. By better understanding the tax advantages of real estate investing, you have a better shot of improving the return on your investment.
Whether it’s your primary house or rental property you just purchased, there are a number of tax advantages all real estate owners should know. Here are some of the ways you can save money at tax time by getting a better understanding of the tax code.
Primary Residence Tax Deductions
As a homeowner, you have the privilege of deducting certain expenses associated with owning real estate. Many of these deductions are available as itemized deductions on Schedule A of the 1040 US individual tax return.
In order to use Schedule A, your itemized deductions must be greater than the standard deduction for your filing status. For example, if you are single you get a $12,000 standard deduction. You would need your itemized deductions in total to be greater than the $12,000 in order for it to make sense to itemize on Schedule A. If your itemized deductions are only $5,000 then there is no advantage to itemizing because you can take the much higher $12,000 standard deduction. There are a variety of itemized deductions available for your main home expenses.
Schedule A: Itemized Tax Deductions For Your Primary Residence
- You can deduct all mortgage interest paid on your first and second mortgages up to $1 million of debt ($500,000 single or married filing separately)
- Property taxes can be deducted (limited to $10,000 in state and local property taxes, and school taxes)
- You can deduct your mortgage insurance premiums (phased out after 2019)
Saving On Taxes When Selling Your Home
There is a main home exclusion for those who sell their primary residence. If you lived in the house for 2 out of the last 5 years, then you may qualify for the main home exclusion. This exclusion is $250,000 for single filers and $500,000 for married filing joint.
For example, if you and your spouse buy a house for $500,000 and sell it for $1 million and lived in it for 2 out of the last 5 years, then you may not have to pay tax on your capital gain.
When you sell your home you may receive a form 1099-S for proceeds from a real estate transaction. If you receive this form, then you will need to include it when you file your income taxes for the year. This is when you can indicate it was a sale of your main home, and if you are eligible, use the main home exclusion.
Can I Take A Loss On The Sale Of My Home?
If you are selling your main home for a loss, unfortunately there are no tax advantages for you. You cannot recognize losses on personal use property such as your home or your car. Some investments, like the stock market, allow you to write off some capital losses.
Rental Property Tax Deductions
When you own a rental property and lease it to make a profit, you will have to report this profit or loss on your annual tax return. You will most likely report this income on a form called Schedule E: Supplemental Income From Rental Real Estate, S-Corporations, Royalties, Partnerships, Estates, Trusts. When you fill out this schedule you can deduct a variety of expenses associated with your rental activity.
- Repairs (painting, plumbing, HVAC, labor, etc.)
- Maintenance (lawn care, HOA fees, light bulbs, filters, cleaning, pest control, etc.)
- Mortgage Interest
- Travel Expenses
- Legal and Professional Fees
- Office Expense
- Advertising Expenses
- Commissions Paid
Rental Property Depreciation
Because rental property is used to generate income, its assets can be expensed over time using depreciation. Depreciation allows you to expense an asset such as a building or machinery over time. Since these assets are capital assets used continuously to generate income, you cannot expense all of the cost in one year. Instead, you have to split up the cost of the asset over its useful life and depreciate it year over year. The IRS provides guidelines on the useful life of assets. For example, the useful life for residential real estate is 27.5 years.
Passive Activity Loss Limitations
You can generally use up to $25,000 of passive losses to offset ordinary income if you are within the phase out and actively participate in the rental activity. The phase out starts once your adjusted gross income reaches $100,000 and is completely phased out at $150,000. This means the $25,000 loss limitation will decrease as you approach $150,000 AGI and will be completely phased out once you hit that threshold.
The advantage here is that all of these disallowed losses can be carried forward to a future date. When you go to sell your rental, all passive losses can then be used to offset ordinary income.
Exceptions For Real Estate Professionals
If you are in the business of buying and selling real estate, then there are no passive activity loss limitations or income phase outs. The IRS has very strict guidelines for who qualifies as a real estate professional.
Real Estate Professional Qualifications
According to 2018 IRS Publication 925
You qualified as a real estate professional for the year if you met both of the following requirements:
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated. You can’t count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer.
So, what activities apply? Any real property:
- Rental activity that is not a passive activity.
- Construction or reconstruction.
- Acquisition and/or conversion.
- Development or redevelopment.
- Property management.
- Brokerage activities.
Selling Your Rental Property
When you go to sell your rental property, it can get somewhat complex. First, you have to figure out your adjusted cost basis of the rental. If your sale price exceeds the adjusted basis then you have a gain on the property. You will first have to recapture depreciation which is taxed as ordinary income up to 25%. The rest of the gain will be taxed at capital gains tax rates.
Investment Property Tax Advantages: 1031 Exchange
This type of exchange allows an investor to defer capital gains by exchanging one asset for a similar asset. The 1031 exchange is limited to real property used in a trade or business or for investment. By exchanging the property, you will transfer the basis of your asset to a new asset and pay capital gains at a later date (when you sell the exchanged asset). You cannot use a 1031 exchange for personal use property.
The 1031 Exchange must be of “like kind” properties meaning of the same nature or character, even if they differ in grade or quality. This also includes geographic location, for example, a piece of property held in the United States could not be traded “like kind” for a property held in Spain.
To elect a 1031 exchange, the investor must identify the replacement property less than 45 days before the closing. The replacement property must be acquired within 180 days after closing. Typically, you must use a qualified intermediary to facilitate the 1031 exchange transaction.
In a 1031 exchange, the property exchanged may not always be of the same dollar value. For this reason, you may have to add cash to the deal to equalize the exchange. This addition of cash in a 1031 exchange is called “boot”. Since this cash (boot) is not like kind, it is taxed to the receiver at capital gains tax rates.
Taxes On Inherited Properties
When you inherit property, you get a tax break from the IRS. It is much more advantageous to inherit property vs receiving it as a gift. When you inherit a property, you get what is called stepped up basis.
Stepped Up Basis
When you inherit property, you will get stepped up basis which is the fair market value at the date of death. Rather than inheriting the decedent’s basis, which is typically much lower, the property’s basis will now most likely be closer to its current price.
Because you can get stepped up basis, it is almost always better to inherit property vs receiving it as a gift. If you were to receive a house as a gift, you will attain the basis of the original owner. This could cause very high capital gains if you were to then sell the gifted property for a gain.