For high income individuals, taxes can be a costly factor that eat into the returns of any investment. Assume paying ordinary income or short term capital gains rates at 33%, your returns takes 10% return down to 6.66%. And while that doesn’t sound horrible, that results in $200,400% haircut over 20 year period and an initial investment of $300,000.
Real estate tax benefits are often overlooked and there are arious ways which property owners can use them to minimize their taxes and enhance total returns. Tax benefits allow real estate investors to write off costs for depreciation, mortgage interest, running, managing, and maintaining a property. And then at the end of it all, exchange the gains into another property thus deferring taxes.
That’s why real estate investing is appealing to high income earners!
Real Estate Investing’s Top 7 Tax Benefits
There are various ways for real estate owners to benefit from tax write-offs, and here are six of the tax benefits that will add to your total return.
1. Real Estate Depreciation
Real estate depreciation allows real estate owners to receive a tax break because it allows them to spread out the property’s purchasing costs throughout its useful life. If a rental property satisfies the following criteria, the IRS will permit depreciation:
- If you are the property owner.
- If the property is part of your business or an income-producing activity.
- If the property wears, becomes obsolete, decays, or loses its value from natural causes, it has a determinable useful life.
- If the property is projected to be used for longer than a year.
- If the property was not put into operation, was sold, or ceased to be used for commercial purposes during the same year.
The MACRS (Modified Accelerated Cost Recovery System) depreciates residential rental properties, but only if it is put into service after 1986. MACRS spreads the property’s depreciation deductions over 27.5 years, which is considered its useful life.
Although you can reduce your taxes by depreciating your property, you should know that if you sell it for more, you will have to pay a depreciation recapture tax on the profit. Various real estate investors exchange one investment property for another with a 1031 exchange to postpone gains or losses that would have been paid at the time of sale.
2. Mortgage Interest Deduction
You can deduct the mortgage interest from a business expenditure if you own rental property. You must receive a 1098 form from your lender annually that shows your mortgage interest expenses which you use to fill out a Schedule E 1040 form on your tax return. The money you spend paying off your mortgage’s interest might be deducted from your income.
A mortgage interest deduction applies to money spent on interest and does not apply to any money spent on the principal mortgage and excludes commissions and appraisal fee expenses.
3. Repair And Maintenance Costs
As well as the well-known depreciation procedures, repairs and maintenance offer the best possibility for tax savings. Suppose repairs are done to maintain the property and keep it rentable. If the costs don’t raise the property’s worth significantly, they are tax deductible.
Here are improvement examples accepted by the IRS Publication 527:
- Patios and porches
- Heating and air conditioning
- Security systems
- Storm windows
- Interior upgrades like kitchen, wall-to-wall carpeting, built-in appliances, and assorted repairs
If you hire a contractor or specialist, you can write off the labor expenses. You can only deduct tool and equipment rental fees if you prefer the DIY route.
4. Property Taxes
The amount of property tax that state and municipal governments collect varies depending on where the rental property is located. Property taxes can cost anywhere between a few hundred and several thousand dollars. You can write off any associated vacation rental or landlord license fees in states that require rental licensing.
The IRS only permits a total deduction of $10,000 for local sales, income, and property taxes. If you are married and file your tax returns separately, you are limited to $5,000 each, and you cannot write-off local or state taxes more than the limit.
Occupancy tax charged by various states to those who manage short-term rentals is tax deductible, as well as inspection fees and any wage and security taxes paid for staff members.
5. Travel Expenses
Real estate often requires some traveling, and those expenses are tax deductible. You can write off your travel costs as long as they are specifically stated if you have to go to collect rent or perform repairs or maintenance. There are two travel expense deduction methods:
- Using the expenses
- Using the standard mileage rates.
The IRS’s Publication 463 provides all the details on deducting traveling expenses, the reporting process, what expense records are required as proof, and all the reimbursement possibilities. Staying current with the latest IRS publications is crucial as they undergo frequent revisions.
6. Legal And Professional Fees
Many of the legal and professional expenditures associated with real estate are tax deductible. A legal advisor or lawyer may occasionally write a lease agreement for a fee or hourly rate; these costs may be a tax write-off. Evictions and disputes over lease agreements could also call for legal counsel or representation; those fees are tax-deductible.
Various other professional fees are tax deductible and include:
- Fees paid to a certified real estate accountant
- The costs or commissions a real estate agent receives for locating tenants
- Advertising in a newspaper, radio, or television outlet
- Any advisory services about the real estate
Legal and professional fees from operating expenses are tax deductible. Still, Legal fees surrounding improvements to the property, defending, or recovering a property’s title cannot be deducted from tax.
7. 1031 Exchange
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, is a tax-deferred strategy that allows real estate investors to sell an investment property and reinvest the proceeds into another like-kind property while deferring the capital gains taxes. Here are some of the tax benefits associated with a 1031 exchange:
Capital gains tax deferral: The most significant benefit of a 1031 exchange is the ability to defer capital gains taxes that would typically be due upon the sale of an investment property. By reinvesting the proceeds into another property, investors can defer paying taxes and keep more of their investment capital working for them.
Increased purchasing power: With capital gains taxes deferred, investors can reinvest the full proceeds from the sale into a new property. This allows for greater purchasing power and the potential to acquire a more valuable property or diversify their portfolio.
Wealth accumulation and compounding: By deferring taxes, investors can keep their money invested, potentially allowing for greater wealth accumulation and compounding over time.
It’s important to note that a 1031 exchange requires compliance with specific rules and timeframes, such as identifying a replacement property within 45 days and completing the exchange within 180 days. Consulting with a qualified tax professional is recommended to ensure eligibility and proper execution of the exchange.
Maximizing your real estate tax benefits can result in significant savings and a high return on investment. You might be amazed at the sum of money that you can save. Mortgage interest deductions, property taxes, travel expenses, repair maintenance costs, and legal and professional fees are six areas where real estate owners can enjoy great tax benefits.