Must Know Real Estate Tax Saving Strategies for Investors

Question

Real estate can be a rewarding investment, but it also comes with various financial responsibilities, including taxes. Fortunately, there are several tax-saving strategies that property owners can utilize to maximize their returns while minimizing their tax liability. As a nationally recognized real estate oriented CPA, our firm very frequently discusses these strategies with clients who hold investments in real estate.

In this article, we will explore some essential real estate tax-saving strategies.

1. Understand Tax Deductions:
One of the fundamental strategies for reducing your real estate tax liability is to understand and leverage tax deductions. Common deductions for property owners include mortgage interest, property taxes, and certain home improvement costs. By keeping track of these expenses and providing accurate documentation, you can lower your taxable income and, consequently, your tax bill.

2. Depreciation:
Depreciation is a valuable tax strategy for owners of rental properties. The IRS allows you to deduct a portion of the property's value each year to account for wear and tear. This non-cash deduction can significantly reduce your taxable income, leading to lower tax payments.

3. 1031 Exchange:
A 1031 exchange, also known as a like-kind exchange, allows real estate investors to defer capital gains taxes when selling one property and buying another. By reinvesting the proceeds from the sale into a new property, you can defer the tax bill until you eventually cash out. This strategy can provide a substantial advantage in building long-term real estate wealth.

4. Use Tax Credits:
Some locations offer tax credits for specific real estate activities, such as investing in low-income housing or energy-efficient upgrades. These tax credits can be a powerful tool for saving on your tax bill while contributing to important community or environmental initiatives.

5. Properly Structure Your Investments:
The way you structure your real estate investments can have a significant impact on your tax liability. Consider options like setting up a limited liability company (LLC) or utilizing a real estate investment trust (REIT) to take advantage of favorable tax treatment.

6. Keep Meticulous Records:
Accurate record-keeping is essential for any real estate investor. Document every expense, improvement, and transaction related to your properties. Not only does this help ensure you're taking full advantage of available deductions, but it also provides essential protection in case of an audit.

7. Consult a Tax Professional:
Real estate tax laws can be complex and ever-changing. To ensure you're making the most of available tax-saving strategies, it's advisable to consult with a qualified tax professional or accountant who specializes in real estate taxation. They can help you navigate the nuances of the tax code and provide personalized guidance based on your specific situation.

In Conclusion, Real estate tax-saving strategies are a vital aspect of optimizing the financial benefits of property ownership. By understanding and implementing these strategies, you can reduce your tax liability, maximize your returns, and ultimately achieve your real estate investment goals. However, it's essential to stay informed about tax laws and consult with tax professionals to ensure you're making the best choices for your unique situation.

Account Closed · Answer

Of course! I'd be happy to provide some clarification on both depreciation and the 1031 exchange strategy:

Depreciation Example:
Depreciation is the process of allocating the cost of an income-producing asset over time, even though the property may appreciate in value. Let's break it down with a simple example:

Imagine you own a rental property that you purchased for $200,000. The IRS allows you to depreciate the property over 27.5 years for residential real estate. This means you can deduct approximately $7,273 ($200,000 divided by 27.5) from your taxable income each year due to depreciation.

Now, let's say your rental property generates $10,000 in rental income annually. Without considering depreciation, you would pay taxes on the full $10,000. However, with the depreciation deduction, your taxable income is reduced to $2,727 ($10,000 - $7,273). This reduction in taxable income results in lower taxes owed.

Limitations on Depreciation:
While depreciation is a valuable tax-saving tool for rental property owners, there are a few limitations to be aware of:

• Recapture: When you sell the property, you may need to pay back some of the depreciation deductions you've claimed as depreciation recapture tax. The rate for this tax can be as high as 25%.
• Depreciation Stops After 27.5 Years: Depreciation can only be claimed for a maximum of 27.5 years for residential rental properties. After that, you can no longer take depreciation deductions.
• Not Applicable to Personal Residences: Depreciation is generally not available for your primary residence; it is meant for income-producing properties like rental homes or commercial real estate.

Now, onto the 1031 exchange:

1031 Exchange Duration and Considerations:
A 1031 exchange is a powerful strategy for deferring capital gains taxes, but it's not indefinite. Here are some key points to keep in mind:

• Time Limit: The IRS provides a time limit to complete a 1031 exchange. You typically have 45 days from the sale of your old property to identify potential replacement properties and 180 days to complete the purchase of one or more of them.
• Like-Kind Requirement: The replacement property must be of "like-kind" to the property you're selling. This does not mean they need to be identical but should be used for investment or business purposes. For instance, you can exchange a residential rental property for another residential rental property.
• Complexity: 1031 exchanges can be complex, and it's essential to follow the IRS guidelines carefully. Working with a qualified intermediary is often advisable to ensure the exchange complies with regulations.
• Potential Gain Recognition: If you cannot meet the deadlines or do not adhere to the like-kind requirement, you may be subject to capital gains taxes as if you had sold the property without an exchange.
• Repeat Exchanges: You can continue to use the 1031 exchange strategy repeatedly, effectively deferring capital gains taxes as long as you meet the requirements each time.

Investors should be aware that 1031 exchanges involve specific rules and regulations, so it's crucial to consult with a tax professional or 1031 exchange expert when considering this strategy to avoid any potential pitfalls and ensure a successful exchange.

KC Pake · Answer

Awesome article, Kislay.  Very informative!I have a couple of quick follow-up questions.  Thanks in advance for your response.

Regarding Depreciation: For those new to real estate investing, the concept of depreciation as a non-cash deduction can be confusing. Can you provide a simple example that illustrates how depreciation benefits a property owner in practical terms? And, are there any circumstances where a rental property owner wouldn't be able to take advantage of this deduction?

On the Topic of 1031 Exchange: You mentioned that a 1031 exchange allows real estate investors to defer capital gains taxes. For how long can an investor continue to use the 1031 exchange strategy? Are there any limitations or potential pitfalls investors should be aware of when considering this approach?

Cheers,
KC

Account Closed · Answer

Navigating the tax implications of a real estate investment LLC in a community property state like Texas can be complex, especially when you're both a Realtor and the LLC has both properties held in its name and properties held personally. It's always a good idea to consult with a tax professional or accountant to ensure that you're in compliance with the tax laws and maximizing your tax benefits. That said, I can offer some general guidance.

• Treatment as a Single-Member LLC: If you elected to treat your LLC as a single-member LLC for tax purposes, then it's generally reported on your personal tax return using Schedule C (Profit or Loss from Business). This is a common practice for LLCs with only one member, and it simplifies tax reporting.
• Rental Properties in an LLC: If you have properties held in your LLC's name, the income and expenses related to those properties are typically reported on Schedule E (Supplemental Income and Loss) of your personal tax return. Schedule E is specifically designed for reporting rental real estate income and expenses. The fact that your LLC owns these properties is a common arrangement for real estate investments.
• Community Property State Consideration: In community property states like Texas, income earned during the marriage is often considered community property and is typically split equally between spouses for tax purposes. This can affect how you report income and deductions, including those from the LLC.

Given your specific situation, here's a suggested approach:

• For properties owned by the LLC: Report the rental income and expenses on Schedule E. Since it's owned by the LLC, this is the standard way to report rental income.
• For properties owned personally: If you have properties in your individual names, those would also be reported on Schedule E, as rental income. However, make sure to clearly differentiate them from the LLC-owned properties.
• For your real estate activities as a Realtor: Continue to report these activities on Schedule C.

In summary, it's not unusual for a single-member LLC with rental properties to use both Schedule C and Schedule E, depending on whether the property is owned by the LLC or personally. You may want to amend your 2021 return to report the rental income and expenses on Schedule E for consistency, but consult with a tax professional to ensure that you are in compliance with community property laws and taking full advantage of available deductions and credits. Additionally, tax laws can change, so it's always a good idea to stay updated or seek advice from a professional who is aware of the latest regulations and can tailor a strategy to your specific situation.

Deanne Wagner · Answer

Thank you for the detailed reply. It is indeed boggling my mind. Lol. I put off my 2022 extension filing the other day because it looked like we were getting a refund and I figured I should fix 2021 before finalizing 2022.

I have talked with a couple tax professionals and get some conflict between them.  To clarify, my husband is not a realtor, he has a regular day job.

My confusion comes from the fact that we have an LLC bank account and EIN.  We have been running everything relating to the 2 properties (the one owned by the LLC and the one owned personally) through the account. We set up the LLC to run it as a business.  It sounds like what you are saying is that I have to note which property each expense/rent is for and basically have a P&L for each separate property?   If that's the case, then where do expenses specific to the LLC go?  Like the Texas Franchise tax, office supplies, insurance, advertising, etc?  Do those just go on a schedule C (one for me and one for my husband splitting the totals in half)?  If everything else goes on the Sch E then the Sch C seems like it will always be a loss.  You wouldn't report the income on both schedules?  Maybe I should not have elected to be treated as disregarded entity and just dealt with the 1065?  What happens with rentals then?

I also wonder if it's worth trying to do a deed subject to the mortgage in order to get the personal property under the LLC umbrella?

I also understood as a realtor that I got some special treatment of the activity that took it out of passive?  I do a Sch C for all my real estate activities not related to our properties.  I haven't yet billed the LLC for work I do for our properties.  That might be something interesting to consider.

What do I look for in finding a competent tax professional that will be well-versed in these specific areas?   I'm in the Dallas/Fort Worth area.

Thank you!

Dave Foster · Answer

@KC Pake, The 1031 exchange will allow you to indefinitely defer the tax as long as you own the property, or sell and do another 1031 exchange.  Or if you hold the property until you die your heirs will receive the property at a step up in basis - the tax disappears for your heirs.  the power here of course is that the 1031 allows you to keep the compounding effect of deferred tax working for you throughout your life.  And then extend that benefit permanently to your heirs.

Deanne Wagner · Answer

This article was very helpful. I've been stuck in a tax debate and wondering if you have any advice to offer to point me in the right direction. My husband and I (live in Texas - Community Property) set up an LLC the end of 2020 to invest in single family residences (rentals).  We elected to be treated as a single-member LLC for tax purposes so we didn't have to do a 1065.   I'm also a Realtor.

We filed our 2020 LLC on 2 Sch. C (split everything in half).  We only had the LLC set up costs that year.

For 2021, we also filed 2 Sch. C and split everything in half. We acquired 1 property in the LLC name and had a lot of expense that year and a loss.

Now in 2023 we acquired 1 more property but had trouble getting a decent loan in the LLC name so we bought it in our names.

I've gone back and forth over whether the Sch C was the right filing instrument to report income/expenses.  I keep reading 99.9% of the time it should be on Sch. E.  But then there are all these exceptions for realtors and the single-member community property states.  Should I amend 2021 to a Sch. E and stay that way going forward?  How confusing does 1 property being owned by the LLC and one not make everything?  :)  We intended to run everything for these rentals through the LLC business account.   I can't find any great answers on IRS sites.

Must Know Real Estate Tax Saving Strategies for Investors

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