Tax Benefits of Real Estate Investment
You can get many tax benefits of real estate investment by owning an investment property. Investors dealing in real estate get the maximum tax benefits in the name of deductions. Deductions that are accounted for can be depreciation, property tax, repairs or any other form of expenses. Tax benefits of real estate investment are many, and these breaks in taxes are helpful to a lot of people dealing with real estate as their full time business.
5 Important Tax Benefits of Real Estate Investment
If you are planning on increasing your wealth, the best investment to deal in is the real estate. The important benefits of investing in real estate are increase in property value due to appreciation, good cash flow in the form of rental income and some incredible tax benefits. Following are the 5 important tax benefits of real estate investment.
Lower Capital Gains Tax
Capital gains are the profits you make when you sell a property. One of the tax benefits of real estate investment are there are lower taxation rates on your capital gains. The gains that investors get from selling their real estate investment property are termed as capital gains which are of two types as mentioned below. Low tax rates on capital gains are an advantage if you build your long-term investment strategy around strategically sell real estate for growth or living expenses. Generally in all tax brackets capital gains taxes are considered better than the equivalent income tax on your ordinary income.
- Short-Term Gains: The gains that are received from investment properties which are held for less than one year are called short-term gains. Investors have to pay tax according to the bracket under which they fall. There is no special tax benefit in real estate for short term capital gains.
- Long-Term Gains: The gains that are received from investment properties which are held for more than one year are termed as long-term capital gains. The tax rate is lower in the long term capital gains because of which investors prefer the latter over the former. The long term capital gains tax are either 0%, 15%, or 20%, depending on what income tax bracket you are in.
Like any other asset residential real estate is also an asset that breaks down over time. Depreciation is a deduction taken on materials that breaks down. The IRS uses depreciation to acknowledge that an asset wears down over time. It is like an allowance given for exhaustion or wear and tear of the property, including a reasonable benefit for obsolescence. Depreciation is charged in different years for the residential and commercial property. For residential properties, it is calculated in 27.5 years, and for commercial, the same is 39 years.
It is an incredible benefit given by IRS to real estate investors. Even though anything that breaks down on the property we are able to deduct it, we all know that property values generally go up over time. Therefore, depreciation on real estate is often known as a “phantom deduction” because although we deduct the cost, the actual loss never really occurs.
Depreciation is charged by the method named as (MACRS) Modified Accelerated Cost Recovery Method. In MACRS the residential rental property and structural improvements are depreciated over 27.5 years, while appliances and other fixtures are depreciated over 15 years. Whatever is the cost of your residential property (excluding cost of the land), it will be spread out over 27.5 years and deducted every year.
If your property is worth $100,000, it will be spread out over 27.5 years, which means you would divide $100,000 by 27.5 = 3636.36. Hence, you can deduct $3636.36 every single year for the next 27.5 years on your investment property.
The catch in depreciation as a tax benefit of real estate investment is that when you sell the property, that entire deducted amount may be taxed at a 25% rate, in addition to any other capital gains taxes. However, if you didn’t make money on the sale, then IRS will not tax your old depreciation amount.
As a real estate investor you can use this tax code called 1031 Exchange to sell a property and use the profit to buy a new one which is of equal or greater value. In this way you can defer paying taxes until that next property is sold or you can opt for another 1031 Exchange. When you choose to sell your property, you are required to pay taxes for your capital gains. With the help of section 1031 of the Internal Revenue Code, you are permitted to postpone paying taxes when you reinvest those gains in another property. IRS considers that you are exchanging you old property for another real estate property.
This is one such type of swap in which there is no tax payed; it is deferred legally. Some of the factors which 1031 exchange must meet are as under:
- The property which has been replaced and the property or properties bought in its place must have the same or greater value.
- The IRS requires that you identify the property you plan to buy within 45 days and you also must close on that property within 180 days.
- The properties included in the transaction must be similar. A real estate property cannot be exchanged for some other type of asset, such as a real estate investment trust (REIT).
- The exchanged properties should be used for any productive purpose in business such as for investment.
- Any cash or property received through the transaction that is not considered like-kind property is considered boot and is subject to taxation. Therefore, you can touch the cash. You must use an intermediary who will hold onto the cash while you wait to close on the new deal. If you do want to take out some of the profit, that amount will be taxed.
No FICA Tax
The Federal Insurance Contributions Act helps in the splitting of tax between the employee and the employer, and the rate of tax is 15.3%. If you are self-employed and have no employer, you are responsible for the full 15.3%, which is known as Self-Employment Tax. Now you might be thinking what is tax benefit here for real estate investors. The US Government does not currently look at rental real estate as a job or self-employed business. Therefore, a rental property income is not generally taxed as “earned income” and does come under FICA.
Remember, it depends on how you earn from real estate. If you own a holding company and draw a salary, you would come under FICA.
Tax Benefits From Refinancing Your Mortgage
Refinancing also considered as one of the tax benefits of real estate investment. Exchanging your old mortgage with a new one at a new interest rate is known as Refinancing your Mortgage. Refinancing provides the borrower with fresh money at lower interest rates due to which the homeowner can lower his/her monthly payment amount. As he/she obtains the loan at a lower rate of interest and consolidates all the debts, he/she now has to pay only one loan amount, which is obtained at a lower rate of interest and is left with some cash in hand. You don’t need to pay taxes on this. You’ll need to pay taxes when you sell the property, but you can use that money right now with no tax at all. The cash in hand after refinancing is non-taxable.
Concluding Thoughts on Tax Benefits of Real Estate Investment
The tax benefits of real estate investment are numerous. It depends on the investors and how they utilize these investments to the best of their advantage. One can attain financial freedom by learning the right way to invest in the real estate industry. It is wise to hire a good CPA who will save you more money than they cost. They will help you in plotting your tax strategy because the US tax code is quite complex and it is difficult to understand all the rules and regulations.
4 Good Markets For Reaping Tax Benefits of Real Estate Investment
- Houston Real Estate Market
- Dallas Real Estate Market
- Atlanta Real Estate Market
- Birmingham Real Estate Market
You can also click on this link to read our blog on how to be a successful real estate investor. This blog will teach you how to succeed in your first real estate investment, going with moderate pace, learning much, and being ready to leave any enticing opportunity that comes in your way. In short do not make hasty decisions out of temptation because the money lost in a bad investment cannot be recovered so easily.