Anyone that’s not in the real estate field may be scratching their head at this. How can you avoid taxes with real estate? The answer is actually quite simple. Real estate investments are a great way to diversify your portfolio, grow your wealth and offset income tax liabilities that are unavoidable with an ordinary job.
The tax implications of buying and selling real estate can be complicated. What you may not know is that there are strategies to help mitigate the taxes from a real estate investment when you sell and increase your wealth. Below are four strategies to getting more out of your real estate investing.
Real estate is a great investment. It can grow in value and provide you with rental income. But before you invest, you’ll need to know how to avoid paying taxes on your real estate profits.
There are two main ways to avoid paying taxes on your real estate profits: deferring gains by taking out a mortgage and reducing your taxable income by taking losses.
Deferring Gain by Taking Out a Mortgage
You can defer the tax on any capital gain from selling an asset if you use the proceeds to buy another like-kind asset or a new home within 180 days of the sale. You can also defer it for up to 10 years if you use the proceeds for qualified education expenses related to yourself or your dependents, or for medical costs exceeding 7.5% of adjusted gross income (AGI).
Reducing Your Taxable Income by Taking Losses
You can reduce your taxable income by deducting any losses from selling real estate against other types of income (like wages or interest). You also get a deduction for depreciation on buildings and land improvements over their useful life, which reduces taxable income and increases cash flow from rental properties.
Investing in real estate continues to be one of the best ways to build wealth and cut taxes. Benefits include the ability to recover the cost of income-producing property through depreciation, to use 1031 exchanges to defer profits from real estate investments, and to borrow against real estate equity to make additional investments or for other purposes.
- Investing in real estate is a way to build wealth and reduce taxes through a variety of means.
- Depreciation allows for the recovery of costs related to income-producing rental property.
- Investors can defer taxes by selling an investment property and using the equity to purchase another property in what is known as a 1031 like-kind exchange.
- Property owners can borrow against the home equity in their current property to make other investments.
- Depending on the property sale value, home-owners can be excluded from capital gains taxes on the gains of their home sale.
- Individuals are also able to deduct the interest paid on their mortgages.
1. Using Depreciation Deduction
You can recover the cost of income-producing rental property through annual tax deductions called depreciation. The Internal Revenue Code defines the depreciation deduction as a reasonable allowance for deterioration, wear and tear, and a reasonable allowance for obsolescence.1
Real estate investors generally use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS), in which residential rental property and structural improvements are depreciated over 27.5 years, while appliances and other fixtures are depreciated over 15 years.
Depreciation expense often results in a net loss on investment property even if the property actually produces a positive cash flow. This loss, as well as expenses, such as utilities and insurance, are reported on Schedule E, federal income tax Form 1040, and deducted from ordinary income.2
2. Taking Advantage of 1031 Exchanges
The 1031 exchange, named for Section 1031 of the Internal Revenue Code, allows investors to defer taxes by selling one investment property and using the equity to purchase another property or properties of equal or greater value. This exchange must occur within a specified period of time.
Although a 1031 exchange can broadly include various types of property, the vast majority of transactions relate to real estate. And from Dec. 31, 2017, onward, Section 1031 “like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment, other than real property held primarily for sale.”3
Property Regulations
In order to successfully complete a 1031 exchange, the properties must meet the following criteria:
- The aggregate value of the replacement properties must be equal to or greater than that of the relinquished properties.
- The properties included in the transaction must be like-kind, meaning real property cannot be exchanged for some other type of asset, such as a real estate investment trust (REIT).
- Both properties must be held for “productive purposes in business or trade” (an investment).45
Any cash or property received through the transaction that is not considered like-kind property is considered boot and is subject to taxation. Cash boot includes not only cash but also physical property, such as fixtures. Mortgage boot refers to any debt reduction that is achieved through the transaction. Thus, the amount of debt assumed with the replacement property must be equal to or greater than the value of the debt retired when the relinquished property is sold.67
Investor Regulations
The investor must use a qualified intermediary. A qualified intermediary is an agent who facilitates the 1031 exchange process, largely by holding net proceeds from the relinquished property before they are re-invested in the replacement property. Only a qualified intermediary may hold those funds during the exchange. The Federation of Exchange Accommodators details the role that the qualified intermediary plays in the 1031 exchange process.8
The investor is subject to two deadlines:
- Forty-five days after the sale of the relinquished property they must deliver a written list of the qualified replacement property to a qualified party to the exchange, usually the intermediary. There are also several rules that limit the number of properties that can be identified.
- Additionally, they must purchase the aggregate value of qualifying replacement assets within 180 days of selling the relinquished asset or 180 days after the due date of his tax return for that year, whichever occurs first.5
1031 Exchange, Step by Step
In a typical transaction, an investor decides to sell an investment property and invest the proceeds from any gain in another property.
- To accomplish this in a tax-efficient way, the investor enters into a 1031 exchange agreement with a qualified intermediary and puts the original property up for sale. At the same time, the investor begins searching for replacement properties.
- On the day the investor sells the original property (the relinquished property), the net proceeds after paying all expenses are sent to a special account set up by the qualified intermediary.
- The investor then enters into the identification period and has exactly 45 days to produce a list of qualified replacement properties and 180 days to close on the replacement property during the exchange period.
- Using the entire proceeds from the sale of the relinquished property, the investor closes on the new investment property or properties.
- The qualified intermediary wires those funds to the title company, the special account is closed and the transaction is completed.
3. Borrowing Against Home Equity
Investors who have built up sizable equity in either their personal home or investment property may simply choose to refinance their properties and pull out equity to make additional investments, improve the home, or for other purposes. Regulations vary from state to state.
In a typical scenario, a lender will loan 80% to 85% of your equity. For instance, on a $240,000 property with a $100,000 loan, the most a borrower could extract is $112,000 ($240,000 – $100,000) x 0.80 = $112,000).9
The ability to borrow against your equity will also depend on your credit score, your existing debt-to-equity ratio, and your debt-to-income ratio.
While this strategy is a bit riskier, for those able to handle the additional debt, it can help build wealth without having to enter into a 1031 exchange or sell a property.
4. Deferring Taxes on the Sale of a Home
Gains from the sale of a taxpayer’s primary personal residence are excluded from capital gains taxation up to $500,000 for married couples that file jointly and $250,000 for single individuals if the taxpayer has lived in the home for two of the last five years. In addition, should the gains from the sale of a taxpayer’s primary residence be greater than those exclusions, the taxpayer may also invest that portion through a 1031 exchange.10
Investors who live in areas where home values are appreciating can use a strategy of trading up to both build their personal wealth and minimize taxes at the same time.
5. Deducting Mortgage Interest
Homeowners can deduct the portion of their mortgages attributable to interest payments on their tax returns. These payments are higher during the early years of the mortgage and gradually decrease as the mortgage is paid off.
According to the IRS, “you can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1 million ($500,000 if married filing separately)) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017.”11
The Bottom Line
There are many options available to the real estate owner who is looking to sell while minimizing tax liability.
- A 1031 exchange allows the returns from a sale to be reinvested into a like-kind property.
- A home equity loan taps directly into the value of the property and can be used for a variety of purposes.
- The sale of a principal residence is eligible for special tax treatment.
- Mortgage interest can be deducted at tax time.
Your personal situation will dictate which of these options is right for you, but any of them will help you get the most out of your real estate investment.
Tax Benefits Of Real Estate Investing
1. Use Real Estate Tax Write-Offs
One of the biggest financial perks of this income stream is the real estate investment tax deductions you’re able to take. You get to deduct expenses directly tied to the operation, management and maintenance of the property, such as:
- Property taxes
- Property insurance
- Mortgage interest
- Property management fees
- Cost to maintain and repair the building
But did you know that you can also write off much of what you pay to run your real estate investment business? Qualified business expenses may include, but aren’t limited to:
- Advertising
- Office space
- Business equipment (e.g., computer, stationery, business cards, etc.)
- Legal and accounting fees
- Travel
All of these deductions lessen your taxable income, which could save you money when you pay taxes. Let’s say your rental income is $25,000, and your related, qualified expenses come to $8,000. That means the taxable income from your real estate business is $17,000.
Pro tip: Be sure to keep detailed, accurate records and receipts so you can prove the expenses you claimed in case you’re audited by the Internal Revenue Service (IRS).
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2. Depreciate Costs Over Time
Depreciation is the incremental loss of an asset’s value, generally due to assumed wear and tear. As a real estate investor that holds income-producing rental property, you can deduct depreciation as an expense on your taxes. That means you’ll lower your taxable income and possibly reduce your tax liability.
You’re allowed to take the depreciation deduction for the entire expected life of a property (currently set by the IRS as 27.5 years for residential properties and 39 years for commercial properties).
For instance, maybe you purchase a home you intend to rent out. The value of the building itself (excluding the land it sits on) is $300,000. If you divide that value by the 27.5 year expected life of the dwelling, you can deduct $10,909 in depreciation each year.
Once you sell, though, be prepared to pay the standard income tax rate on the depreciation you’ve claimed. This requirement is known as depreciation recapture, which you can avoid if you pursue other tax strategies, like a 1031 exchange (more on that below).
Pro tip: Ask your accountant about depreciating major improvements you’ve made to your investment properties, such as installing a new roof.
3. Use A Pass-Through Deduction
A pass-through deduction allows you to deduct up to 20% of your qualified business income (QBI) on your personal taxes. When you own rental property as a sole proprietor, via a partnership, or through an LLC or S Corp (known as pass-through entities), the money you collect in rent is considered QBI by real estate tax law.
For example, if you have an LLC that owns an apartment complex, you could receive $30,000 in rental income every year. By using a pass-through deduction, you can write off up to $6,000 on your personal return. Of course, some rules and regulations must be followed, so please consult with your accountant.
Please note: This perk, along with other provisions in the Tax Cut and Jobs Act of 2017, is currently set to expire in 2025.
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4. Take Advantage Of Capital Gains
A capital gains tax may be assessed when you sell an asset, like a piece of property, for a profit. There are two types to be aware of: short-term and long-term. They each impact your tax situation differently.
Short-Term Capital Gains
When you profit from selling an asset within a year of owning it, you realize a short-term capital gain. While you may not have a choice but to sell, be aware that doing so can have a negative effect on your taxes. That’s because the gain gets counted as ordinary income.
So, if you earn $100,000 from your day job and sell an investment property for a $100,000 profit, your income essentially doubles for tax purposes. If you file single, that extra income puts you in the next tax bracket (as of 2020), which potentially means a larger tax bill than you expected.
Long-Term Capital Gains
On the other hand, you see a long-term capital gain if you profit from the sale of an asset that you’ve held for a year or longer. If you can wait until the anniversary of your purchase to sell, you’ll get to keep more money in your pocket. That’s because long-term capital gains have a significantly lower tax rate than your standard income.
And, if your income is low enough, you may not have to pay the tax at all. Suppose you and your spouse make a combined $75,000 per year and file a joint tax return. The long-term capital gains are tax-free since the tax rate for your income level is 0%. That means you can keep every cent of the profit you get when selling a property.
5. Defer Taxes With Incentive Programs
Sometimes, the government develops a special tax code to incentivize investors. Let’s review the 1031 exchange and opportunity zones, two major real estate tax benefits.
1031 Exchange
1031 exchanges exist because the government wants to reward people who reinvest their real estate profits into new deals. As long as the new property you buy is of equal or greater value than the one you sell, the program lets you swap them for tax purposes. That means you can defer paying the capital gains tax on the sale of the first property.
You can use 1031 exchanges indefinitely. But, when you want to cash out your profits, you’ll have to pay any tax owed. There are a few different forms of the program available based on the timing of your purchase and sale transactions. Since the program can be complicated to navigate and take full advantage of, it’s wise to consult with a qualified financial professional.
Opportunity Zones
Designated by the US Department of Treasury, opportunity zones are low-income or disadvantaged tracts of land. The 2017 Tax Cuts and Jobs Act encourages investors to put their money into developing and economically stimulating these communities by offering tax breaks.
Alongside other real estate investors, you place your unrealized capital gains into a Qualified Opportunity Fund. Money from that fund goes toward improving the selected area.
If you play by the rules of the program, you can enjoy the following tax advantages:
- Defer paying capital gains until 2026 (or until you sell your stake in the fund).
- 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 remain invested in the fund for 10+ years.
6. Be Self-Employed Without The FICA Tax
When you’re self-employed, you generally need to pay both the employer and employee portion of the FICA tax (covering Social Security and Medicare). However, if you own rental property, the money you receive isn’t classified as earned income. That means you’re eligible for one of the least talked about real estate tax breaks: avoiding the FICA tax, also known as the payroll tax.
Here’s the math in action:
Let’s pretend you own a freelance writing business that generates $50,000 in revenue. Since that money is considered earned income, you’re on the hook for the payroll tax. At a 15.3% tax rate, you’d have to fork over $7,650. But, if you’re a rental property owner instead, you would get to keep that cash in the bank.