Real estate investments can come with many potential benefits, especially when the property was strategically bought.
With this type of investment, you can grow your personal wealth by boosting your passive income, all while diversifying your portfolio.
Unfortunately, investment property owners aren’t taking full advantage of this opportunity because they aren’t as knowledgeable about the related tax benefits as they should be.
Leaving these benefits on the table prevents you from keeping a larger share of your ROI (return on investment).
In the following paragraphs, you’ll learn all about the main tax benefits that you could be missing out on:
Benefit #1: Depreciation
This is a big tax break. The depreciation of rental properties recovers income producing property costs. This means yearly tax deductions.
The IRS applies depreciation deductions to acknowledge the fact that assets wear down. Nothing stays intact forever. This benefit balances the wear and tear of the property.
How does this play out in real life? There are three factors determining the annual depreciation deductions:
- Property’s recovery period
- Property’s worth
- Depreciation method
The last point is vital. Usually, investors use something called the Modified Accelerated Cost Recovery System (MACRS). Based on this system, the rental property and structural improvements depreciate over 27.5 years.
This applies to residential rental properties. Meanwhile, the appliances and fixtures depreciate over 15 years. The depreciation excludes the cost of land, though.
Let’s conduct a sample calculation:
Your property is worth $250,000. When spread out over 27.5 years, this means we have to do the following calculation.
$250,000 divided by 27.5 = $9,090.90
In a period of 27.5 years, you can deduct $9090.90 on your property every single year.
That’s a great tax benefit. Things do break down on the property, but at the same, property values tend to increase.
This the reason why real estate depreciation is sometimes called a phantom deduction. People deduct costs, yet there are no actual losses.
Benefit #2: Lower Capital Gains Tax
When you sell a property, the profits you make are capital gains. Real estate investment leads you to have lower tax rates on the capital gains. It needs to be kept in mind that there are two types of capital gains: short-term gains and long-term gains.
You’ll receive short-term capital gains from properties that you held for less than a year. This type of capital gain receives no special treatment. You pay taxes according to your regular tax bracket.
Long-term capital gains, on the other hand, favor property investors because the tax rate is lower compared to the short-term type.
In order to benefit from this, you have to hold the property for over a year. Typically, long-term capital gains and rental properties go hand in hand.
Out of these two, long-term capital gains are the best bet for investors. Your taxation rate will be much lower. It’s going to be 0%, 15%, or 20%. The rate depends on your tax bracket. Plus, you can use previous deductions for lowering the taxable amount.
Benefit #3: 1031 Exchange
The name stands for Section 1031 of the Internal Revenue Code. The section describes swapping a real estate investment asset for another one. Most of these swaps are taxable as sales.
But 1031 provides an appealing exception. At the time of exchange, a swap falling under the 1031 Exchange has no tax. Or just limited tax.
In other words, you can take the gains from one real estate investment into the next one. You avoid the taxes until selling the property.
This tax code has important rules you must follow. Let’s take a closer look:
- Identify the property within 45 days. Close the property within 180 days.
- The properties have to be similar. You can’t exchange a real estate property for any other type of asset.
- The replaced property and the property (or more than one of them) bought in its place have the same or greater value.
- Funds have to be kept by an intermediary. They will hold the funds until the completion of the acquisition.
- Exchanged properties will be used for any productive business purpose, including investments.
Benefit #4: No FICA Tax
FICA stands for the Federal Insurance Contributions Act. The rate is 15.3%. It’s split between the employer and their employee.
Self-employed people are responsible for the whole amount. In this case, you might call it the Self-Employment Tax.
Currently, income from rental properties isn’t considered as an “earned income.” It’s not a job or a business. Hence, there’s no tax under FICA. Nonetheless, there’s an important exception.
Let’s say you own a holding company and you pay a salary to yourself. Then the FICA will apply to you once again. You’ll have no tax exemption.
The bottom line: what are the tax benefits of real estate investing?
Investing in real estate comes with many tax advantages. Some of them are universal. Depreciation applies to all the typical investment properties.
Others have fine print. For example, you need to hold a property for over a year to get the tax rate for long-term capital gains. No FICA tax applies when you pay yourself a salary from a holding company.
You should use all the available tax benefits to keep more of the profit. If it seems overwhelming, consult with an expert to plot out a winning tax strategy.