Real Estate: The Ultimate Tax Deduction

Real Estate: The Ultimate Tax Deduction

You know it, we know it: 2021 was challenging. The pandemic continued to drive economic hardships like stunted supply chains and omnipresent inflation. But with so much outside of our control, there’s no time like the present to set some personal financial goals and get our ducks in a row.

One such duck is our taxes. As a real estate investor, it’s possible that you’re not entirely aware of the tax breaks you can capitalize on. Please note that this list isn’t exhaustive; there are even more tax-slashing strategies at your disposal. That said, let’s dive right in.

 Itemized Deductions

Expenses incurred in the operation, management, and maintenance of a physical property can be deducted from a real estate investor’s taxes. These include (but are not limited to): property taxes and insurance, mortgage interest, management fees, and building repairs. But you, the investor, can deduct certain business expenses as well.

That new laptop you purchased to work from is a write-off. So is your office space, consulting fees, and marketing spends. And the travel costs to scout new opportunities or wine-and-dine potential partners? Better save those receipts too.

All of these examples can be used to reduce your annual income, thus lowering your total tax liability.

 Depreciation = An Investor’s Best Friend

Weapons of Mass Depreciation

A property’s loss of value over time is known as depreciation. As an owner/investor, you can take this depreciation as a loss on your taxable income. There are two primary ways to go about this:

Straight-Line Depreciation

The most simplified way is to divide the property’s value (excluding the land) by its useful life. Typically, real estate is depreciated over 27.5 (residential) or 39 years (commercial). If your residential rental property is worth $1 million, divide it by 27.5 to calculate the allowed deduction, which comes out to $36,363.

Accelerated Depreciation

But property owners know that things don’t degrade at the same rate. The IRS knows it too, and thus allows investors to depreciate the property’s individual elements (e.g, plumbing, electrical, roof, carpets, kitchen appliances) on 5-, 7-, or 15-year schedules. Note that this must be done through a cost segregation analysis using a certified professional.

Incentive Programs

Here’s the thing: our federal government wants private entities investing in real estate. Someone has to manage the 43.6 million rent-based households in America, right? Uncle Sam ultimately thinks, “better them than us.” As such, they incentivize real estate investors to, well, keep investing.

1031 exchanges, for example, allow for the difference of capital gains tax on a property’s sale if the proceeds go toward purchasing another property of equal or greater value. (Note: while 1031 exchanges can be utilized indefinitely, you’ll need to pay taxes owed if you ever want to cash out.)

Qualified Opportunity Zones (QOZs) are economically distressed areas where new investments may be eligible for preferential tax treatment, serving as a win-win for both investors and the local community. By adhering to the program’s rules, you get to reap the following rewards:

Defer paying capital gains until December 31, 2026, or until you sell your shares.

Grow your capital gains by 10% if you hold the fund for 5 years; 15% for 7 years.

Avoid paying capital gains entirely if you stay invested in the fund for 10 or more years.

The Self-Employment Loophole

The self-employed are generally responsible for paying both the employer and employee portion of the FICA tax, which includes Social Security and Medicare. However, the rental income isn’t subject to that same tax treatment, meaning real estate investors can avoid the FICA tax. Let’s look at how this might shake out:

Say you’re a freelance business coach that earns $100,000 in annual revenue. At a 15.3% payroll FICA tax rate, you’ll get hit with a $15,300 tax bill every year. But if you’re a rental property owner making that same income. you get to sidestep that bill completely and keep your hard-earned cash.

 A Word to the Wise

These tax breaks are complex; you’ll likely want to hire an expert CPA or tax professional to take full advantage of them. If you don’t, you could be missing out on HUGE savings every year. But certain programs in particular, like acceleration depreciation and 1031 exchanges can be incredibly nuanced and may incur penalties if applied incorrectly. Our best advice is to accountant up.