As real estate investors, we’re always looking for ways to maximize returns and cash flow, and that includes being smart about taxes.
With the right planning and strategy, you can minimize tax liability without crossing legal boundaries.
Here are a few options:
1031 Exchange
If you plan to sell a property and are open to investing in a new one, a 1031 exchange may be a viable option.
A 1031 exchange can be an effective way to defer capital gains tax when selling an investment property by reinvesting the proceeds into another similar property.
Here’s a simplified look at how this works:
- Sell your existing property.
- Identify a suitable replacement property within strict deadlines.
- Use a qualified intermediary to facilitate the exchange and hold the proceeds from the relinquished property until the transaction is complete.
1031 exchanges allow you to defer capital gains tax while growing your investment portfolio.
Real Estate Investment Trusts (REITs)
REITs are companies that own, operate and finance income-generating real estate. Typically, they specialize in certain types of properties (e.g., apartments or shopping centers). Investments can be made through the purchase of shares on major stock exchanges.
REITs don’t usually pay corporate income tax, but rather, they distribute income to shareholders as dividends. Dividends are typically taxed as ordinary income, but a portion may be considered a tax-deferred return of capital or may qualify for a lower capital gains tax rate.
Cost Segregation Study
A cost segregation study is a detailed analysis of a property that aims to reclassify certain components as personal property or land improvements. These components depreciate over a shorter period of time (5-15 years vs. the standard 27.5 years for residential or 39 years for commercial properties).
Accelerating depreciation can help lower your tax burden in the early years of property ownership.
Cost segregation studies are best performed by qualified and experienced professionals.
Opportunity Zones
Investing in an Opportunity Zone can also offer tax incentives. Opportunity Zones are economically distressed areas designated by the U.S. Treasury Department.
If you invest capital gains into a Qualified Opportunity Fund, you can defer the taxes on those gains until December 31, 2026, or until you sell your investment (whichever comes first).
By holding your investment in the fund for at least 5 years, you receive a 10% reduction on owed taxes on the original capital gains. If you hold your investment for 7 years, that reduction increases to 15%. Hold that investment for 10 years, and you may be able to permanently exclude gain from a qualifying investment when it’s sold or exchanged.
Of course, there are other strategies you can use, including the simplest one: maximizing deductible expenses.
What strategies are you using?
