You’ve probably heard that only two things in life are certain: death and taxes. While real estate investment can’t help stave off the grave, they can help with the tax man. Most real estate investors focus on the benefits of cash flow, appreciation, and portfolio diversification. While those are incredible benefits of owning rental properties, they don’t tell the whole story.
We are going to explore the tax advantages of investment properties.
Reduced Tax Burden
A tax deduction is any item the IRS allows you to subtract from your income when calculating your tax burden. If you make $150,000 but have $10,000 in deductions, you are only paying taxes on $140,000. Every dollar you can deduct is one less dollar on which you pay taxes.
Thankfully, investment properties are a treasure trove of deductions. Property taxes, repairs, maintenance, property management fees, mortgage interest, insurance, and fees to advertise your listing may all be deductible. Even hiring a tax professional to help you find more deductions on your property is likely a deduction.
Simply put, this means you keep more of the money you make. The expenses to maintain your investment properties cost you less because they lower your tax burden.
People sing the praises of appreciation in real estate investing. As an investor, your net worth grows as the value of your investment appreciates. Even though it seems counterintuitive, you also benefit from depreciation. That’s because it creates another form of tax deduction, and the moment your property is available for rental, you can start depreciating it.
A 25-year-old house isn’t quite as nice as a brand-new house. The wood floors have scratches, a tile in the bathroom is outdated and cracked, and the walls have all the dings and dents that come from daily living. These things all decrease the value of the building to potential buyers.
Even the best tenants cause wear and tear and some minor damage just by using your rental property. The IRS acknowledges this by allowing you to depreciate the value of your residential rental property over 27.5 years. Every year, you may deduct 1/27.5 of the value of the structure from your taxes.
That means that on a $200,000 house, you can deduct $7272.72 every year for the next 27.5 years.
A property’s purchase price is the combined value of the land and any buildings on it. It’s important to note that this deduction only applies to the value of the structure, not the land it is on. Your land doesn’t lose value through use like your house does, so you can’t claim land depreciation on your taxes.
Long-Term Capital Gains
When you sell an investment property, your profit is considered capital gains. While you probably can’t escape paying any taxes on that profit, it won’t be taxed at the same rate as regular income. Typically, capital gains tax rates are lower than income tax rates as long as you’ve held the property long-term. That means you pay less taxes on a dollar earned selling your property than a dollar earned from employment.
The IRS classifies long-term capital gains as any profits you make on real estate you’ve held for more than a year. If you sell before the one year mark, your profits get no special treatment.
Look closely at your next paycheck. See that line item labeled “FICA?” That stands for Federal Insurance Contributions Act, and it’s money from your pay that you never receive. You and your employer split the 15.3% FICA obligation to fund Medicare and Social Security. If you are self-employed, you pay the full 15.3% yourself.
While rent from investment properties can feel like a monthly paycheck, the IRS treats it differently. You will still pay income tax on those rent checks, but you do not have to pay the extra 15.3% to cover FICA.
Income subject to fewer taxes means you get to keep more of what you earn.
Passive Income and The Pass-Through Deduction
Thanks to the Tax Cuts and Jobs Act of 2017, rental property owners may be able to take advantage of a new pass-through deduction. The change applies to pass-through businesses, which includes most landlords. This could enable you to deduct 20% of net rental income or 5% of your property’s purchase price and 25% of any employee payroll expenses.
This deduction can be a complex one. When in doubt, consult a tax professional. (Remember, that expense may be a deduction, too.) In general, your rentals must be a business instead of an investment activity, earn a profit for the year, and you must fall under set income limits.
If you are considering investing in residential real estate, you are likely already aware of the wealth-growing benefits of appreciation and cash flow from rental income. But investment properties look even more enticing when you consider the many tax advantages that can accelerate you even more quickly down the path of wealth and prosperity. Through real estate investment, you’ll make more money and keep more of what you make.