If you are planning on increasing your wealth, the best investment to deal with is real estate. Investing in real estate has some incredible tax benefits. Other benefits are an increase in property value due to appreciation and good cash flow in the form of rental income. It is easy to find the lists of these tax benefits of real estate investing, like the ability to deduct nearly every expense associated with the real estate or how to qualify to exclude from your income all or part of any capital gain from the sale of your main home.
However, it is equally easy for someone to inflate or conflate various tax benefits given by the IRS. Investors dealing in real estate get the maximum tax benefits in the name of deductions, which we'll discuss in detail. Deductions that are accounted for can be depreciation, property tax, repairs, or any other form of expenses. These breaks in taxes are helpful to a lot of people dealing with real estate as their full-time business. Let’s look at the top tax benefits of investing in real estate using hard numbers. This is the basic introduction to how tax benefits in real estate work.
The average home in the United States costs around 220,000 dollars. Yet many people don’t need a three or four-bedroom single-family home. Nor should you pay that much for an investment property. A good rule of thumb for investors is to pay no more than 70 percent of the ARV or After Repair Value of the property.
We’re going to use a property purchased for 130,000 dollars. This may be a small starter home in an average neighborhood or a full-sized home in a working-class neighborhood. The house would then be worth around 185,000 fixed up if we were going to pay cash for the repairs. You don’t want to overpay for the property.
- Determine how much the property would rent for it after repairs.
- Divide that by the property value.
- You want a 1 percent rate of return at a minimum.
- This means that if you can rent the property for 1600 dollars a month and have 300 dollars a month in expenses, your net revenue is 1300 dollars a month.
- On a 130,000 dollar starter home, this is a 1 percent ROI and makes it a good deal.
- If the property costs 130,000 dollars now but requires 20,000 in repairs, it probably isn’t worth it unless you’re going to sell it soon to capture the increased equity.
- Don’t forget to factor in expenses like property management fees, property taxes, and insurance if you’re going to hold onto the property in addition to expenses like the mortgage.
Suppose you want to buy a 130,000 dollar house with 20 percent down. That means the down payment is 26,000 dollars. This results in a mortgage of 104,000 dollars. We used a mortgage calculator assuming a 104,000 dollar mortgage at 5 percent over 30. This results in a monthly payment of 558 dollars a month. As a real estate investor, your mortgage interest becomes tax-deductible, while payments toward the principle are not. This makes nearly all of the roughly six hundred dollar house payment a business expense you can write off.
Because you put 20 percent down on the property, there is no PMI or private mortgage insurance.
However, property insurance will be tax-deductible, too. Homeowner's insurance ranges from 1 to 2 percent a year. If we assume a 1 percent homeowner's insurance policy, the premiums are 1200 to 1300 dollars a year. Property management fees are tax-deductible business expenses. If the rent on our 130,000 investment property is 1300 dollars a month, you’ll pay roughly 130 dollars a month or 1560 dollars a year for someone else to collect the rent.
All the costs associated with property acquisition can be written off. This list includes title insurance, legal fees, real estate agent commissions, transfer taxes, back taxes, and closing costs. Don’t be afraid to hire a real estate attorney if it helps you avoid major mistakes. The cost of asking a professional about the tax benefits of investing in real estate is tax-deductible, too.
Property taxes vary wildly across the country. Some states lack a property tax, while the rate may be negligible on rural properties. The average property tax rate in the US is 1.2 percent. This translates to a $1,560 property tax bill for homeowners. Unfortunately, that’s factoring in the homestead exemption property tax investors don’t get.
Assume a $2,000 to $2,400 a year property tax bill. The property taxes you pay offset the potential income taxes you would owe if your real estate properties are held by an LLC. Or they’re treated as a business expense for you as a private investor, reducing the taxable income you’ll owe on the property. Note that you’ll still enjoy the same tax benefits of real estate investing if it is held in a private LLC as held in your name.
What Are Tax Benefits of Real Estate Investing?
Everyone pays property taxes, but how much tax you pay can be reduced by utilizing certain tax breaks available in real estate. Let's now discuss each of these tax benefits in detail and how to use them to maximize your savings.
What is Depreciation?
One of the greatest tax deductions real estate investors enjoy is depreciation. Like any other asset residential real estate is also an asset that breaks down over time. Depreciation is a deduction taken on materials that break down. The IRS uses depreciation to acknowledge that an asset wears down over time. It is like an allowance given for exhaustion or wears and tear of the property, including a reasonable benefit for obsolescence. Depreciation is charged in different years for 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 the IRS to real estate investors. Even though anything that breaks down on the property can be deducted, 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.
How is Depreciation Calculated?
Depreciation is charged by the method named (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 the cost of the land), it will be spread out over 27.5 years and deducted every year.
Note that you can only depreciate the building, not the land.
For simplicity’s sake, we’ll say the land is worth 30,000 dollars while the house is worth 100,000 dollars, which will be spread out over 27.5 years.
This 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.
And that much of the profits from the property are shielded from income taxes because it is offset by the presumed losses from depreciation. This is separate from the tax-deductibility of actual repairs like replacing the roof or dead air conditioner.
If you made major improvements to the property, such as the fixer-upper scenario, those improvements are included in the depreciation. If you bought the house for 130,000 dollars and made repairs and renovations that made it worth 180,000 dollars, you have an additional 50,000 dollars of cost basis to use for depreciation purposes.
Note that minor repairs like a new hot-water heater or patched roof don’t count in depreciation.
Important Tips About Using Depreciation as a Tax Benefit in Real Estate
- Depreciation will start the moment the property is officially available for occupancy.
- This means depreciation doesn’t start the day you bought the property but the day you started trying to sell it or find a renter.
- Conversely, it means you can claim depreciation even if the property is vacant for several months.
- Depreciation ends if you sell it, exchange it or retire it from service as a rental property.
- For example, you can’t claim depreciation if you move into it and make it a permanent residence.
- 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.
Lower Capital Gains Tax
Capital gains are the profits you make when you sell a property. One of the tax benefits of real estate investing is that there are lower taxation rates on your capital gains. The gains that investors get from selling their investment property for sale are termed 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 selling 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 that 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 that are held for more than one year are termed 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 is either 0%, 15%, or 20%, depending on what income tax bracket you are in.
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 that 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 your old property for another real estate property. This is one such type of swap in which there is no tax paid; it is deferred legally.
Here are some of the factors which the 1031 exchange must meet.
- 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 the 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 is also considered 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.
How Do You Take Advantage of These Tax Breaks?
The simplest approach is to document all of your expenses from property repairs to ongoing maintenance to insurance to taxes. Track one-time expenses like the cost of listing it for rent or sale. Your accountant will total up these expenses to determine your total business expense write-off. More importantly, what you pay your attorney or accountant to manage your business is also a tax-deductible business expense. The costs of acquiring and fixing up a property occur on a case-by-case basis.
Let’s jump to the tax calculations for the second year of ownership. We’ll use conservative estimates, though you might keep costs down.
Property taxes – $2000 a year
Depreciation – $4000 a year
Mortgage interest – $6000 a year
Property management – $1560 a year
Repairs – $2000 a year
Insurance – $1300 a year
Legal and tax preparer fees – $500 a year
That totals up to $16,860 a year in expenses. We already estimated an income of $1,300 a month every month or $15,600 a year. In this case, you’d owe no income tax on the property. If you were charging $1,500 a month in rent, you’d pay a little more in property management fees but only have to pay income taxes on $2,000 a year. In reality, you’re clearing closer to $6,000 a year, because you aren’t paying for the property’s depreciation. Know that these are rough, back-of-the-envelope calculations regarding the tax benefits of real estate investing. The costs and benefits of owning a particular property should be done on a case-by-case basis.
How Can You Lower Your Tax Bill as a Real Estate Investor?
Hold the property for more than a year to reduce capital gains taxes on the property’s appreciation. This makes a fix and rents a better strategy than flipping houses. You could even buy run-down properties, fix them up, manage them for 13 months, and then sell them to another investor. Just don’t get yourself classified as a dealer instead of an investor, because the self-employment category will double your FICA taxes.
Another option is owning the property as a legal liability corporation. You can receive the profits from the LLC, but you are personally shielded from lawsuits. You have some control over when you sell the property or pay the property taxes. Run the numbers. You might want to delay paying the property tax bill until January next year to offset the profits if you had a major repair bill this year.
If you sell the property, you’ll owe capital gains taxes. A like-kind exchange under Section 1031 of the tax code allows you to defer paying these taxes. Always work with a good real estate tax advisor to handle such a rollover. Another option is selling the property to the tenant or another investor under an installment deal. It lets you write off the value of the property with each installment, though you run the risk of only owning half a house if they default.
In theory, you can reduce your tax bill by borrowing against properties you own to buy new properties rather than selling them, too. On the other hand, you don’t want to pay more for repairs, services, or financing to get a tax write-off. For example, you’re not saving money if you pay the bank an extra 1000 dollars to get a 250 dollar tax write-off.
Set up a dedicated home office that you only use for work. Then you can deduct part of your mortgage and utilities as a business expense. Get organized. For example, you should keep track of mileage and travel costs, so you can include them as business expenses on your taxes. Document what you pay to attend real estate investing seminars or software you buy to run your business.
For simplicity’s sake, set up a bank account that is only used for managing rental properties. Rent is deposited into the account, and you only pay expenses for the rental properties out of that account. Then you don’t accidentally try to write off personal home repairs. However, this approach does make it difficult to write off a home office.
Concluding Thoughts on Tax Benefits of Real Estate Investment
Real estate investing enjoys many tax benefits. It is one of the most tax-advantaged investments compared to other investments. It depends on the investors and how they utilize these investments to the best of their advantage. It requires careful planning and effort to maximize your tax deductions while remaining in compliance with the complex regulations involved. 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 or tax expert 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.
Tax Benefits of Real Estate: Places Where You Can Reap Maximum Benefits
Here are some of the best states in the U.S. for owning a property. This list takes into account median home values as well as state and local tax rates, including income tax rates, and property taxes as a percentage of market value or assessed tax value (whichever is applicable). If you buy a property or live there, it’s an excellent investment. We have listed each state's effective property tax rate, median home value, and calculated annual taxes on median home values —for an easier understanding of these tax rates.
The tax rates have been taken from Smartasset.com and median values have been taken from Zillow.com.
Alabama has both a low tax rate and home prices that are well below the median home value in the U.S. For residential property, the assessed value is 10% of the appraised (or market) value. So, for example, a home with an appraised value of $100,000 would have an assessed value of $10,000. We have taken the median home value as an assessed value without any exemptions.
Median Home Value: $143,072
State Income Tax Rate: 2% – 5%
Avg. Effective property tax rate: 0.42%
Annual Property Taxes: $600
Nevada's average effective property tax rate is just 0.69%, which is well below the national average of 1.08%. There are numerous tax districts within every Nevada county. County Assessors are required to reappraise all property at least once every five years. The assessed value is equal to 35% of that taxable value. Thus, if your County Assessor determines your home’s taxable value is $100,000, your assessed value will be $35,000. Tax rates apply to that amount. We have taken the median home value as a taxable value without any exemptions.
Median Home Value: $309,730 (Zillow)
State Income Tax Rate: 0%
Avg. Effective Property Tax Rate: 0.69%
Annual Property Taxes: $2,137
The state of Florida's average effective property tax rate is 0.98%, which is slightly lower than the U.S. average of 1.08%. Property tax rates are applied to the assessed value, not the appraised value. The most widely claimed exemption is the homestead exemption. Let’s say you have a home with an assessed value of $100,000. The first $25,000 would be exempted from all property taxes.
The next $25,000 (the assessed value between $25,000 and $50,000) is subject to taxes. Then, the next $25,000 (the assessed value between $50,000 and $75,000) is exempt from all taxes except school district taxes. Finally, the remaining $25,000 is also taxable. We have taken the median home value as an assessed value without any exemptions.
Median Home Value: $252,309
State Income Tax Rate: 0%
Avg. Effective Property Tax Rate: 0.98%
Annual Property Taxes: $2,472
Louisiana has the third-lowest effective property tax rate of any U.S. state. Only Alabama and Hawaii residents pay less on average than residents of Louisiana. For residential property in Louisiana, the assessed value is equal to 10% of the market value. So if your home has a market value of $100,000, your assessed value would be $10,000. It offers a homestead exemption on the first $7,500 of the value of a person’s primary residence (does not apply to city taxes). We have taken the median home value as an assessed value without any exceptions.
Median Home Value: $170,388 (Assessed Value)
State Income Tax Rate: 2% – 6%
Avg. Effective property tax rate: 0.52%
Annual Property Taxes: $886
The average effective property tax rate in Texas is 1.83%, well above the national average of 1.08%. A property appraisal is done annually by county appraisal districts. Tax payments are based on the current market value of a property. However, some exemptions help lower property taxes in Texas. Most popular are homestead exemptions which reduce property taxes for all homeowners by removing part of their home's value from taxation. Only a homeowner's principal residence qualifies for it. It exempts at least $25,000 (for school districts) of a property’s value from taxation. We have taken the median home value as the current market value with Homestead Exemptions of $25,000.
Median Home Value: $211,199
State Income Tax Rate: 0%
Avg. Effective Property Tax Rate: 1.83%
Homestead Exemptions: $25,000
Annual Property Taxes: $3,407
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 a moderate pace, learning much, and being ready to leave any enticing opportunity that comes your way.
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