Real Estate Investing
The Tax Benefits of Real Estate Investing that can help You reduce Taxable Income

The Tax Benefits of Real Estate Investing that can help You reduce Taxable Income

Want to understand the tax benefits of real estate investing and how you can maximize your returns by taking advantage of tax deductions, depreciation, and other tax-saving strategies in real estate? Beyond the potential for rental income and property appreciation, one of the most awesome aspects of real estate investment is its significant tax advantages! Knowing how to leverage these benefits can substantially enhance your financial position. In this blog we get into how the various tax benefits that real estate investing offers, empowers you to make informed decisions and maximize your wealth.

“Wear and Tear” Tax Deductions

First, there are many ways that real estate investing helps you reduce taxable income. The most common is depreciation. The Internal Revenue Service (IRS), gives the property owner the ability to deduct the “wear and tear,” of the property in two ways:

The Standard Depreciation Deductions

One of the most advantageous tax benefits of real estate investing is the depreciation tax deduction. Unlike most assets that lose value over time, the IRS allows property owners to claim depreciation as a tax deduction, even as the property appreciates in value. Depreciation represents the gradual wear and tear of the property and can be claimed over its useful life, typically 27.5 years for residential properties and 39 years for commercial properties.

By taking advantage of depreciation deductions, real estate investors can reduce their taxable income and, consequently, their tax liability. This can result in substantial savings, especially for owners of high-value properties. Additionally, depreciation deductions can be used to offset other sources of income, providing further tax relief.

Bonus Depreciation

Word bonus on top of money. Bonus depreciation is an extra tax deduction to reduce taxable income

Secondly, there is a current “bonus depreciation,” that the new real estate investor can take advantage of. This is due to the Tax Cuts and Jobs Act of 2017. This allowed the ability to depreciate equipment, software, etc, that was purchased in the first year the property is put in service. However, the full bonus depreciation is phased down by 20% each year after Dec. 31, 2022, and before Jan. 1, 2027, when it ends. There are current talks to renew this benefit.

Bonus Depreciation

Year Put in ServiceBonus Depreciation Percentage
2022100%
202380%
202460%
202540%
202620%
20270%

General tax deductions

how to reduce taxable income with property depreciation from real estate investments

In addition to depreciation, there are numerous deductions that can be tax write-offs. There are many expenses when managing your real estate investments. The good news is that many of them can be tax deductions, which helps reduce your tax liability. These can include:

Mortgage Interest Deductions

Another significant tax benefits of real estate investing is the deduction of mortgage interest payments. For properties financed through a mortgage, the interest paid on the loan is tax-deductible, subject to certain limitations. This deduction can substantially reduce taxable income, especially in the early years of the mortgage when interest payments are typically higher on your real estate investments.

Property Tax Deductions

Property taxes are a common expense for real estate investors, but they also offer a valuable tax deduction. The IRS allows property owners to deduct the full amount of property taxes paid during the tax year, subject to certain limitations. This deduction can help offset the overall tax burden associated with real estate investment, particularly in areas with high property tax rates.

Maintenance and Property Management

Another real estate tax-write off, is the maintenance or upkeep costs for the property. These can include repairing a toilet, painting, and even property management fees. However, anything that increases the value of the property (new roof, new patio), is considered an improvement and not able to be used as a deduction.

Defer Taxes on Real Estate Investments

Calendar with taxes due and postponed. How to reduce taxable income with property depreciation from real estate investments

In addition of the many tax benefits of real estate investing, is the ability to defer capital gains for a later time. This can be done with a 1031 exchange.

What is the capital gains tax?

First, what are capital gains taxes? Well, they are a type of tax on the profits earned from the sale of assets. This can include stocks, real estate, businesses, etc. It is calculated by subtracting the original cost of the asset from the sales price. When you acquire assets and sell them for a profit, the IRS looks at these profits (gains) as taxable income. However, the tax percentage that is paid depends whether it qualifies for short-term capital gains (1 year or less), or long-term capital gains (over 1 year).

What is a 1031 Exchange?

When selling a property for a profit, real estate investors may be subject to capital gains tax. However, there are several strategies available to minimize or defer these taxes. For instance, investors can take advantage of the 1031 exchange, which allows them to defer capital gains taxes by reinvesting the proceeds from the sale into a like-kind property. By continually exchanging properties, investors can defer capital gains taxes indefinitely, allowing their wealth to grow tax-free.

Additionally, investors may qualify for the capital gains exclusion on the sale of a primary residence, which allows individuals to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains from taxation if certain conditions are met. This exclusion can provide substantial tax savings for homeowners looking to sell their primary residence.

Passive Activity Losses

Woman calculating how to reduce taxable income with property depreciation from real estate investments

Real estate investing often generates passive income, which is income earned from rental properties in which the investor is not materially involved. Passive income is subject to specific tax rules, including the ability to offset passive losses with passive income. This means that losses incurred from rental properties can be used to offset rental income, reducing or eliminating the tax liability associated with passive income.

However, it’s essential to understand the IRS’s passive activity loss rules, which limit the extent to which passive losses can be deducted based on the investor’s level of participation and adjusted gross income. Proper tax planning and structuring of real estate investments can help investors maximize their ability to deduct passive losses and minimize their tax liability.

Real Estate Professionals

The Internal Revenue Service (IRS) defines a real estate professional as someone who spends more than half of their working hours in the rental business. This may include property development, construction, acquisition, and management. You must also devote more than 750 hours per year to working on your real estate rental properties to qualify as a professional.

Passive Activity

On the other hand, if your rental property is a sideline investment—and you don’t materially participate in the investment—it’s considered a passive activity. In this case, any passive activity losses can be used only to offset passive activity income. In other words, you can’t use any losses from the rental property to shelter other taxable income. Instead, the losses are carried forward until you generate passive income or sell the investment.

All in all, the tax benefits of real estate investing can be a powerful tool for building wealth and achieving financial independence. From depreciation deductions to mortgage interest deductions and capital gains tax benefits, there are numerous strategies available to real estate investors to minimize their tax liability and maximize their after-tax returns. By understanding and leveraging these tax advantages, investors can accelerate their wealth-building journey and create a more secure financial future.

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