5 Important Tax Benefits of Real Estate Investing and Tax Saving Strategies for Investors
This article will make you aware of real estate investment tax benefits and tax saving strategies for real estate investors.
We will discuss effective tools offered by the Government to encourage you to invest in real property:
- tax breaks and deductions
- tax credits
- 1031 exchange
Let’s start our overview of tax advantages of real estate investing by looking at tax breaks and deductions.
Survey of Experts: Which of the following tax benefits for real estate investors have you used?
#1 Real Estate Investment Tax Deductions
Tax write offs for real estate investors were created to encourage investment in the real estate sector.
These are not tax loopholes for real estate investors. They are legitimate tax incentives that help mitigate some of the risks and boost investment in our communities.
Surveys of real estate professionals repeatedly show that many investors would curtail their real property investing or look into other asset types without these incentives.
There are a number of tax advantages of real estate investing in the United States Tax Code.
Your individual situation should be assessed by one of the local CPA for real estate investors or real estate asset managers to make sure that you are taking advantage of all the benefits for which you qualify.
What Are Tax Deductions in Real Estate Investing?
The first type we will discuss is tax deductions. Let’s provide its definition.
A tax deduction is an amount that the Government allows you to subtract from your taxable income (and not directly from your tax liability).
Let’s go over the deductions available to the U.S. real estate investors.
Physical assets like real estate can deteriorate over time. US tax law allows investors to claim that depreciation as a deduction.
You can reduce your taxes because of the wear and tear on your property.
You can deduct for depreciation until the total cost of the property has been depreciated unless the property has been taken out of service and is no longer used as an investment asset.
Cost Segregation Studies allow depreciation to be accelerated by breaking the property down into its individual parts wherein those parts are then depreciated on their own depreciation schedules, typically 5,7 or 15 years instead of 27.5 or 39 years for real estate.
Rental Real Estate Loss Allowance
Small investors who help manage their property may qualify for up to $25,000 in deductions for business losses.
To receive the full deduction, they need to have an Adjusted Gross Income (AGI) of no more than $100,000. If their AGI is between $100,000 and $150,000, their deduction will be less.
Investors with higher incomes do not qualify.
Owners of rental property get deductions for expenses including depreciation on the home.
But if expenses exceed rents to produce a loss, they may only deduct this “passive activity loss” if they have passive activity income or have income under $150,000. This allows them to deduct up to $25,000 of their annual rental loss.
If their rental activity produces income and is operated like a business (profit motive involved and regular involvement by the owner), they can also get a special “qualified business income” deduction on up to 20% of the net rental income.
If you are an active participant, eg, managing your rental, already a real estate agent, directing a manager or agent and being active in your investing, you are able to deduct passive losses from things like depreciation, from active W-2 and 1099 income.
This provides a direct, dollar for dollar deduction of passive (paper) losses from rentals against salary income.
Deductions and savings used by other businesses also apply to real estate investing:
Expense deductions: business expenses like loan interest, management fees, marketing, office rent, professional fees, insurance, maintenance, and travel are deductible.
This makes real estate taxes on investment property deductible.
Pass-through taxation: partnerships, sole proprietors, and S Corporations pay no tax. The business income “passes through” to the owners’ personal tax filing.
This is how a real estate investment loss tax deduction can indirectly lessen your personal tax liability.
#2 Tax Credits for Real Estate Investors
Another type of tax benefits for real estate investors is tax credits, which works differently from deductions. Below is the definition of tax credits.
What Are Tax Credits for Real Estate Investors?
A tax credit is a dollar amount that can be deducted from your tax liability (unlike tax deductions that are subtracted from your taxable income amount).
What Is the Difference Between Tax Credits and Deductions?
As the amount of the credit is the exact amount you can deduct, this is preferable to tax deductions.
Tax deductions help people invest in real estate in general. Tax credits help them to invest in specific areas or specific ways.
Tax credits can be sold to investors generating a significant amount of capital for that project.
Some tax credits induce real estate lenders to make otherwise unappealing loans on good terms.
New Market Tax Credits
Tax credits are awarded to Community Development Entities (CDE), some of which are large financial companies.
Individual investors typically work with a CDE, which provides a loan at favorable terms for projects located in low-income areas.
These loans are interest-only for seven years. After that, if certain terms are met, some portion of the loan can be forgiven.
Low Income Housing Tax Credits (LIHTC)
These credits are available directly to for-profit and nonprofit businesses for the construction or rehabbing of low-income housing.
The sale of these credits can generate as much as 70% of the project’s cost.
Rehabilitation Tax Credits
This credit is available for the renovation of historic and old buildings. The credit is equal to 20% of the rehab costs, not including the purchase costs. Recipients take the credit over 20 years.
In addition to federal tax credits, local municipalities often provide their own programs to spur business and housing activity in low-income areas.
A couple of examples are grants for exterior improvements or enhanced security features.
#3 Other Real Estate Investment Tax Breaks
Below are two other tax benefits of investing in real estate that aren’t classified as deductions or credits.
Avoid Payroll Tax
Unearned income such as rent, profits, and interest earned from real estate investments are not subject to FICA tax. This represents big tax savings for real estate investors.
Lower Capital Gains
In order to encourage investment, the Government allows investors to pay less tax on income from the sale of long term investment properties.
For assets owned for more than a year, the tax savings from long-term capital gains tax rates can save you a lot of money.
Real estate is riskier than some other investments. Lower Capital Gains tax rates help to balance some of that risk by making ventures more profitable.
Returns and profits are greatly enhanced. It’s that simple.
In some cases, reinvesting in an exchange for real property in another state can permanently avoid tax on the transaction.
Investors often refinance the debt on their real estate based on the equity or appreciation and make distributions to themselves.
Frequently, these funds are used to invest in other real estate, trade or businesses, or other investments.
In these cases, it is important to correctly trace the use of proceeds on these debt-financed distributions to take advantage of the allowable deductions on the interest paid.
This is a complicated area of tax and we recommend that investors obtain guidance from an experienced tax professional.
There is an election available pursuant to Sec. 469(c)(7)(A) for those qualifying as real estate tax professionals that could enable them to group their rental real estate activities and treat the income and losses as non-passive activities.
This would enable them to offset real estate losses against other ordinary income, which may be helpful for some taxpayers.
To keep track of all these tax incentives without errors, choose one of the best bookkeeping and accounting software apps for real estate investors from our article about them.
#4 Real Estate Investment Trust Tax Benefits
Individuals can buy shares in a Real Estate Investment Trust (REITs). REITs are a type of real estate private equity firms that invest in and operate income producing properties.
Don’t confuse REITs with other trusts created as a part of real estate asset protection strategies for real estate investors.
If the REIT meets its requirement to pay out 90% of its income to its investors, the REIT pays no corporate tax. This is passed on to its shareholders indirectly through improved profitability.
Dividends from operations of the REIT are ordinary income, and shareholders are taxed accordingly.
However, when assets are sold, the proceeds (if any) are considered capital gains.
This way, investors can be taxed at the much more favorable long term Capital Gains tax rate for that portion of their dividends.
The REIT can also designate investor payments as a return of their capital for which they are not taxed.
Be careful, though, as this will reduce your basis when you sell your shares. Your basis is the amount you invested.
The basis is subtracted from the sale price to determine profits or gains. A smaller basis can create a larger, taxable profit.
Furthermore, your local real estate investment consultants may advise you to buy REIT shares through a 1031 exchange procedure — with the funds received from a sale of real property.
Read on to learn about it and its benefits.
#5 1031 Exchange
Effective tax planning tips for real estate investors should include the use of 1031 Tax Deferred Exchange. For many, this is the most powerful method of how to save on taxes by investing in real estate.
Note the word “deferred.” They eventually have to be paid with one exception which we’ll discuss in a minute.
How a 1031 Exchange Works
When you sell an investment property and use the proceeds to purchase another property (or REIT shares) of equal or greater value, you can defer the taxes otherwise owed on your profits.
The most beneficial tax rule is the 1031 Exchange. An individual investor’s strategy is to grow their equity/capital and increase the size of their portfolio. Being able to keep a property’s appreciation and re-invest it significantly improves returns and strengthens this strategy.
This gives you more capital to invest in a larger property, borrow less for a comparable value property, or diversify your portfolio by acquiring multiple properties.
If the property appreciates, you can refinance and take out some of your equity if needed.
Owners of property held and used for investment or a business can exchange it for other similar property and postpone the gain (or loss) on that exchange if they carefully follow the like-kind exchange rules.
The sale of your relinquished property and the purchase of a replacement property must be conducted in strict compliance with 1031 Exchange identification rules and 1031 Exchange timeline.
The 1031 Exchange, named after the related IRS code section, allows real estate owners the ability to sell property and trade into another property without paying taxes on the gain.
In order to accomplish this, there are very specific rules and timelines imposed by the IRS that the parties must adhere to.
First, you need to be on the title of both the real estate you sold (referred to as Relinquished Property) and be on the title of the real estate you buy (referred to as the Replacement Property).
You cannot sell or buy interests in partnerships or other entities, although those entities may enter into 1031 exchanges.
Next, you need to keep the money received from your exchange with an independent third party, referred to as an Accommodator. The Accommodator also maintains the required paperwork.
Finally, you need to identify the replacement property with the Accommodator within 45 days of the sale of your relinquished property and then close on the identified property within 180 of the closing.
You are allowed to identify several properties under certain rules, but must close on one of those properties within the 180 timeframe.
Now the taxes on the gain are not eliminated, but deferred until the replacement property is sold.
Another major rule is the equity and debt of the replacement property must be at least equal to the cash and debt of the relinquished property or you may incur boot which is currently taxable.
How Do Real Estate Investors Avoid Taxes Permanently?
Below are generalized descriptions of three ways that allow not just defer capital gains, but avoid them either partially or completely by employing a like-kind tax deferred exchange procedure.
It’s worth noting that a like-kind exchange is a complex procedure. To make sure it’s conducted legally, have one of the best 1031 exchange companies in your area oversee the transaction.
§121 Primary Residence Exclusion
Investment real estate, no matter its type, can be exchanged for a residential investment property and then converted to your personal residence.
As a general recommendation, you should own the property for at least two years and rent it each year at market rates for at least 14 days.
Your ability to use the property during that time may be limited.
The deferred gain becomes equity that is protected by the residential property gain exclusion in the tax code. You could avoid paying taxes on some or all of your investment gains.
Homeowners who own and live in their principal residence for at least two years in the five years prior to the sale date can exclude from taxation up to $250,000 of the gain ($500,000 if married filing jointly).
And if they itemize while owning their home, they can deduct mortgage interest on up to $750,000 of debt and deduct property taxes on the home (limited to a maximum state and local tax deduction of $10,000).
Read about this in more detail in the article on how to do a 1031 exchange from a rental property to a primary residence.
Passing a Property Acquired through a 1031 Exchange to Your Heirs
Here is the exception we mentioned. Property acquired through a 1031 Exchange that you hold at the time of your death can be passed on to your heirs without realizing any gain that would trigger a tax liability.
Their “basis” in the property is the value when it’s inherited, not the price you paid for it. You effectively avoided Capital Gains taxes on all the transfers of your investment properties.
A 1031 Exchange is a great tool for estate planning. It creates the ability to pass on valuable assets to your heirs without any offset for taxes. It’s probably second only to a family trust for its effectiveness in estate planning.
Opportunity Zone Funds
Another method for deferring Capital Gains taxes is to reinvest gains from an investment property sale in an Opportunity Zone.
The Opportunity Zones program was created to promote investment in low-income areas, similar to the purpose of tax credits.
Opportunity Zone investments have to be made through a qualified Opportunity Zone Fund.
90% of the assets held by a business such as an LLC, a corporation, or a partnership must be located in Opportunity Zones for that business to qualify as an Opportunity Zone Fund.
Investors or real estate developers simply have to self-designate their company as an Opportunity Zone Fund on an IRS form that they include with their tax filing.
The benefits of this program are multi-layered and some have effectively expired. Originally, gains reinvested in Opportunity Zone Funds were deferred from taxes until December 31, 2026.
By that time, if you had held the property for a certain period of time, your basis on the sale that created the gains was increased which reduced your tax liability.
There isn’t enough time between now and the end of 2026 to hold a property long enough to benefit from those rules.
However, the second and more significant savings are still available to investors.
When an investor reinvests gains through an Opportunity Zone Fund and holds that property for at least ten years, they qualify for a permanent exclusion from taxable income when they sell the Opportunity Zone property.
To know whether a property is located in an Opportunity Zone, go to the hud.gov website where you’ll find a map showing all the Opportunity Zones.
You should also check with the Economic Development or similar office in your state to see if they are piggybacking their own investment incentive programs in those areas.
Opportunity Zones are located in all 50 states, the District of Columbia, and US territories.