Depreciation and Energy-Efficient Improvements
Depreciation Deductions
The cost of your property can be written off as a tax deduction over the course of its useful life, thanks to depreciation. This means you can deduct a portion of the cost of your property each year from your taxable income. Your property must be used for business or income-producing purposes to qualify for depreciation. The IRS has guidelines for how to depreciate your property, so it’s important to consult with a tax professional to make sure you’re doing it correctly.
Energy-Efficient Improvements
Making energy-efficient improvements to your property can qualify you for tax credits. The federal government and some state governments offer tax credits for installing energy-efficient appliances, windows, doors, and other upgrades. These tax credits can help offset the cost of the improvements and lower your overall tax bill.
1031 Exchange or Invest Through Self-directed Roth IRA
You can do a 1031 exchange to defer capital gains taxes. Beyond that, you could move into your investment property for two years, after which you qualify for a Section 121 exclusion, where your first $250,000 in profits ($500,000 for married couples) is tax-free.
Or you could go in reverse: house hack a multifamily property with a low-interest owner-occupied mortgage, live in it for two years, then move out and hold it as a rental for up to three more years. You qualify for a Section 121 exclusion as long as you lived in the property for at least two out of the last five years.
Alternatively, consider investing through a self-directed Roth IRA. Your money compounds tax-free, and you owe no taxes when you withdraw funds in retirement. Of course, it’s hard to buy a $200,000 investment property when you can only contribute up to $6,000 per year ($6,500 starting in 2023).
Consider starting with real estate syndications, which are completely passive investments but still give you fractional ownership of a property. While they usually require a minimum investment of $50-100K (on par with a down payment and closing costs [of] buying a property directly), you can invest in syndications through a real estate investment club to invest with as little as $5K per deal.
Real estate syndications often pay 15-30% returns, so your SDIRA balance can compound quickly. After a few years of maximizing contributions, you will likely have enough to buy an entire property by yourself if you so choose.
As a final thought, you could keep properties indefinitely. When your renters pay off your mortgage, go out and refinance it to pull equity out again and start the process all over. When you die, the cost basis resets and the property becomes part of your estate.
Don’t Sell Within a Year of Purchase
Investors buy and own real estate because it can be a way to build wealth over time, bring in cash flow, and make a profit when the property is sold. But these purchases come with their own problems, and taxes are one of them.
One way to lower the taxes on your property investment is to hold them for more than a year before selling. When you sell something you’ve had for less than a year and make a profit from it, your earnings are taxed at a higher rate. This is an important consideration if you’re interested in house-flipping, for example.
Holding your properties longer than one year will eliminate the chance of being labeled a dealer and changes the way your profits are treated, from regular income to capital gains. Most Americans are taxed 15% for capital gains–this is usually much less than standard income tax rates.
If you flip real estate, you might want to rent the property for a year before selling it. You’d be lessening your tax rate, get some extra cash flow, and can potentially make money if the value of your home goes up once you do sell it. If vacancy periods are a concern, get in touch with a professional property manager who will have the resources that’ll help you find a tenant quickly.
Depreciation, Tax Credits, and Homeowners or Investor Filing Status Benefits
One way to lower taxes on investment properties is to take advantage of depreciation. Depreciation allows investors to deduct the cost of their property over a certain period of time, usually 27.5 years for residential properties and 39 years for commercial properties. This can lead to significant tax savings when filing your return. Additionally, investors may be able to deduct certain expenses related to the property, such as repairs and maintenance. Investors should keep detailed records of any expense related to their investment property in order to maximize their deductions when filing taxes.
Another way to lower taxes on investment properties is to take advantage of tax credits. Depending on where your property is located, there may be state or local credits available for investors. These credits can help to offset the cost of taxes and save money in the long run.
Finally, investors should consider taking advantage of [the] homeowner or investor status when filing their returns. This can provide additional tax savings due to differences in how investment income is taxed depending on your status. For example, homeowners may be able to deduct mortgage interest, while investors may not.
By taking advantage of depreciation and tax credits, as well as understanding the differences between homeowner and investor status when filing taxes, investors can save money on their investment property taxes. Additionally, keeping detailed records of all expenses related to the property can help to maximize deductions and lower taxes even further.
Five Tips To Lower Investment Property Taxes
1. Consider Taking Advantage of Tax-Loss Harvesting: Tax-loss harvesting is a strategy that involves selling investments that have declined in value to generate losses, which can be used to offset the taxable income from other investments. This can help lower your overall tax bill and potentially increase your after-tax returns.
2. Take Advantage of Any Tax Deductions: If you are investing in income-producing property, there may be deductions available for expenses related to the property, such as insurance or repairs. You should also look into whether you can claim depreciation on the property to reduce your taxable income.
3. Set Up a Self-Directed IRA or 401(K): By setting up a self-directed IRA or 401(K), you can use the funds to invest in real estate and other investments while deferring taxes on any profits. This can help you save more money for retirement while also reducing your current tax liability.
4. Work with a Financial Planner: A financial planner can provide guidance and advice to help you optimize your taxes on any investment property. They can help you identify deductions and other strategies for reducing your tax burden, as well as help you manage your overall financial situation.
5. Invest in Tax-Friendly States: Different states have different laws regarding the taxation of investment properties, so consider investing in a state that has more favorable tax laws. This can help you keep more of your profits from the property and minimize your overall tax burden.
By taking advantage of deductions, deferring taxes through retirement accounts, seeking advice from financial professionals, and investing in states with lower taxes, you can potentially reduce your taxes on an investment property.
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