It’s no secret that the tax incentives for real estate investors are one of the reasons real estate reigns as one of the best investments you can make. At least, according to millionaires.
With that said, “taxes” is a scary word more often than not. That doesn’t change when you become a real estate investor, even if new avenues for reducing tax liability are opened to you. Before I begin, I want to preface this with a disclaimer.
I’m not a tax professional.
I’ve just been in this business for a long enough time to know a thing or two. With that said, you should always consult a qualified CPA or other tax professional before proceeding with anything tax-related. Ideally, whoever you consult should have a background in real estate taxes and working with investors. This way you ensure that you maximize your benefits and minimize your liability—without getting in trouble with Uncle Sam.
An overview of the tax system
The United States works on what is called a progressive tax system. You know how it goes—you pay a higher percentage of tax on your income based on tax brackets. As your income increases, so does your tax liability based on that income bracket and your filing status. This is known as your “marginal tax rate.”
Now, your tax bracket is not what percentage of taxes you pay on all of your income. Let’s look at the current tax brackets, updated in 2017 through the Tax Cuts and Jobs Act. These numbers have been updated for 2020, during which the IRS made adjustments based on inflation.
|Tax rate||Filing single||Married filing jointly||Married filing single|
|10%||Up to $9,875||Up to $19,750||Up to $9,875|
|12%||$9,876 to $40,125||$19,751 to $80,250||$9,876 to $40,125|
|22%||$40,126 to $85,525||$80,251 to $171,050||$40,126 to $85,525|
|24%||$85,526 to $163,300||$171,051 to $326,600||$85,526 to $163,300|
|32%||$163,301 to $207,350||$326,601 to $414,700||$163,301 to $207,350|
|35%||$207,351 to $518,400||$414,701 to $622,050||$207,351 to $518,400|
|37%||$518,401 or more||$622,051 or more||$518,401 or more|
If you were a single filer, you would pay 10% in taxes on the first $9,875 you make. Anything above that and up to $40,125, you would pay 12% on, so on and so forth up the scale.
As real estate investors, we look for ways to reduce our effective tax rate. This is the average rate at which your earned (wages) and unearned (dividends) income are taxed and it is more indicative of the true rate at which your income is being taxed.
Of course, that just has to do with income. When it comes to real estate, there is some nuance in how taxes work.
How real estate is taxed
Capital gains are taxed differently than regular income. This is the profit earned when selling an asset, be it property, stocks, or something else. Capital gains themselves are broken down into two categories that are taxed separately.
Short-term capital gains are taxed by your same tax bracket. Because the U.S. tax system wants to encourage long-term investments, however, long-term capital gains are in a different, more favorable set of rates.
Long-term capital gains
|Tax Rate||Filing single||Married filing jointly||Head of household|
|0%||Up to $39,374||Up to $78,749||Up to $52,749|
|15%||$39,375 to $434,549||$78,750 to $488,849||$52,750 to $461,699|
|20%||$434,550 or more||$488,850 or more||$461,700 or more|
For the real estate investor, it is more advantageous, tax-wise, to hold properties for a minimum of one year to qualify for long-term capital gains versus short-term gains. Capital gains are not as simple as comparing the price you bought it for to the price you sell it for. Real estate capital gains include the expenses related to that property’s acquisition and sale, such as real estate commissions, legal fees, closing costs, and other associated fees.
Acquisition costs are added to the total cost of the property at acquisition. Sales costs are deducted from the price of the sale. Therefore, your long-term capital gains tax liability is probably lower than you think it is.
Rental income taxes
Like capital gains, rental income is taxed differently. This is where your tax filing might become a little more complicated. On the surface, rental income is taxed along with any other income in your designated tax bracket.
However, real estate investors can effectively demonstrate a “loss” even if their rental income is in the black.
First things first, what is rental income? Rental income includes:
- Rent payments
- Advance rent payments
- Kept security deposits
- Expenses the resident pays to deduct rent cost (i.e., water bills)
- Services given in exchange for rent reduction
You can deduct the following expenses from rental income:
- Costs for cleaning and maintaining the property
- Insurance costs
- Mortgage interest
- Advertising expenses
- Property management payments
- HOA or condo fees
- Services and utilities
- Legal fees related to the property
Every state in the U.S. has property taxes. On average, you will pay 1.18% annually on your property’s value. However, states vary. This is just one reason why where you invest matters. The rate in New Jersey, for example, is 2.44%. In Hawaii? Just 0.27%.
For the real estate investor, this makes out-of-state investing make that much more sense. If you have higher taxes in your local market, you can focus your investment efforts on states and markets with lower tax rates.
Then, we enter the big benefits for real estate investors.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Finding the tax advantages in real estate
Depreciation is the key benefit for real estate investors. In comparable terms, it’s like deducting a business expense. Effectively, you can deduct the cost of your residential rental property throughout its “useful life,” which the IRS defines as 27.5 years. You would divide the cost of the property, minus its land value, by 27.5.
For a property worth $200,000, an investor is looking at a yearly deduction of over $7,000. This can greatly reduce the tax liability incurred on rental income. You’re reducing your taxable income but not cash flow—and that’s crucial.
Depreciation is non-negotiable. The IRS will force you to take it whether you want it or not. The only reason an investor may balk at this deduction is because of depreciation recapture. This is when a property is sold and the IRS taxes the amount deducted through depreciation (based on the number of years you have received a deduction).
In this, gains and losses are recognized based on an adjusted cost basis (versus the original cost basis). The adjusted cost basis is the original purchase price of the property, minus the total amount of depreciation deductions written off in taxes for as long as you have held the property.
This amount is then subtracted from the property’s sale price. This is called a realized gain. The remaining amount is what is taxable as a part of recapture. There is no recapture if the asset was sold at a loss.
There are, however, ways to circumvent recapture and capital gains taxes, such as a 1031 exchange that defers your capital gains taxes.
Capital gains taxes could steal a little bit of your appreciation thunder. However, there are ways to defer these taxes. When you are a buy-and-hold investor, your ability to reduce tax liability only increases. If you never intend to sell, you will never have to worry about capital gains taxes.
As you hold the property, you will pay off the mortgage, increase your overall cash flow, and increase your net worth. Plus, you can pass your wealth on to the next generation. It might sound morbid, but dying without selling your property does indeed benefit you in terms of taxes.
The 1031 exchange
A 1031 exchange is a strategy in which an investor exchanges property for a “like-kind” property or properties of equal value. Not only can this be an excellent way to diversify your portfolio, but it also allows you to defer capital gains taxes.
There are specific guidelines to this strategy and it employs the use of a qualified intermediary (QI) as well as some strict deadlines. However, it can be enormously beneficial for an investor looking to diversify or “level up.”
A property that has appreciated since its purchase can be exchanged for a property of that new value, which will likely come with a higher rental rate based on its location and condition.
Depreciation and the 1031 exchange get a little complicated. You don’t get to fully “reset” depreciation in that you are suddenly able to depreciate your new property starting from scratch. Instead, you must calculate a new cost basis. Because you essentially transfer the history of one property into another, you have to use the same cost basis as your original, sold property.
Your cost basis only changes if you paid more for the replacement property than you received from the relinquished property. In this case, the difference is added to your cost basis.
There are two ways to deal with this: take the newly adjusted cost basis and start depreciation from there. It’s simpler to start a brand new depreciation schedule, but investors can benefit from keeping separate schedules (and are encouraged to). The remaining depreciation from the relinquished property continues for the remainder of the 27.5 years, while the additional cost of the replacement property is depreciated on a new schedule.
I could spend forever discussing a self-directed IRA (individual retirement account), but I’ll keep it brief for now. The major benefit of an IRA is the ability to invest tax-deferred. In a self-directed IRA, non-traditional assets, like real estate, are available for investment. Like a regular IRA, contributions to the account are also tax-deductible.
With that said, there are many rules to the SDIRA. Here are few key qualities to note:
- A 10% penalty is incurred if you withdraw before the age of 59.5.
- Federal taxes are due at withdrawal.
- You cannot self-deal. You cannot use SDIRA funds to invest in your own company, you cannot reside or work on a property owned by your SDIRA, and disqualified individuals (such as family members) cannot rent said property.
Despite this (and many other) regulations, however, an SDIRA allows investors to minimize tax liability and build up their retirement accounts.
The pass-through deduction
As part of the Tax Cuts and Jobs Act of 2017, a 20% tax reduction on business income was offered through 2025. This is the Qualified Business Income (QBI) deduction. While who and what kind of rental income qualifies is debated among tax professionals, it is possible for investors to qualify, particularly if they employ the use of a pass-through entity like an LLC.
We know that two things are inevitable: death and taxes. For the real estate investor, just how much those taxes have a hold on our lives can be dramatically improved. If anything, you can leverage taxes and the tax law to your advantage.
The tax benefits in real estate investment are complicated and vast. The biggest barrier to utilizing them is a lack of awareness. This is why it’s so valuable for real estate investors to partner with a CPA with experience in dealing with real estate investors.
At the end of the day, you want a professional who can help you navigate—and benefit from— the tax code without worry or stumbling. With that said, there is far more detail and nuance to taxes for real estate investors. This is the tip of the iceberg.
If anything, this guide can help you tap into under-utilized strategies so that, at the end of the day, you can maximize your success in real estate investment.