Tax Benefits from Investing in Real Estate (Part 1)
Everything you need to know in 2 minutes
For most Americans, real estate will be the costliest purchase of their life. A small subsection of Americans will go on to purchase more than one home with the intent of generating recurring cash flow from renting it out. In both instances, the federal tax code has clear benefits available to purchasers that can be leveraged at the time of purchase and even throughout ownership.
Here are some of those benefits outlined for the individual investor:
Tax Write-Offs
Purchasing an investment property means you will receive recurring rental income from your tenant. You are allowed to deduct the operational expenses tied to the investment property, such as:
Property insurance
Property management fees (if you’ve outsourced the management)
Repairs
Advertising
Legal
Travel
Mortgage interest
These deductions will lower your taxable income and, subsequently, your tax liability. You should keep a careful record of your expenses and receipts in case of an IRS audit.
1031 Exchange
The 1031 Exchange is an incentive program to retain capital within the real estate asset class. When you sell your residential property and purchase new property of equal or greater value you are allowed to defer capital gains taxes from the gains recognized in the sale.
There is no limit to how many times you can use 1031 exchanges, but when you eventually want to sell a property without any intention of purchasing a new one, you will finally be required to pay some tax. This legal tax avoidance rule continues to be one of the best tax benefits available to the individual taxpayer.
Opportunity Zones
Created in the 2017 Tax Cuts and Jobs Act, Opportunity Zones are portions of land determined by the US Department of Treasury to be low-income or disadvantaged. This program incentivizes investors to allocate capital to purchasing and developing housing and commercial properties by offering significant tax breaks. Investors can choose to invest independently or with a group of investors via a fund.
Some of the tax advantages of investing in Opportunity Zones include:
If you remain invested in the Zone for 10+ years, you can avoid paying capital gains entirely.
If you exit the property or fund earlier than ten years, you can defer paying taxes until 2027.
Depreciation
Depreciation is defined as "a reduction in the value of an asset with the passage of time, due in particular to wear and tear." More importantly, this is a deductible tax expense available to all real estate investors, which does not require them to spend cash. So investors can reduce their taxable income and tax liability without cash outflows.
You are allowed to deduct depreciation over the life of the property, which is 27.5 years for residential properties and 39 years for commercial properties.
However, you'll have to pay tax on the depreciation captured when you sell the property. Of course, you can avoid this by using a 1031 exchange as described above.
Note - This is Part 1 of 2 on tax benefits available to those investing in real estate. It is important to keep in mind that these types of transactions tend to have significant details in the small text and the smartest approach is to work with a tax professional. For only the next 30 days, Reconcile offers a free matchmaking service for taxpayers in need of tax professionals, please fill out this form to learn more: https://airtable.com/shre0ZVAsZAjlyK8D.