The Tax Benefits of Real Estate Investing: What to Know
Be Thoughtful About Every Investment Property Tax Deduction
A rental property owner can get many benefits from tax deductions. Most of the expenses associated with your building can be deducted for tax purposes. If your building brings in $1,000 in rental income, you have to pay taxes on the full $1,000 if you don't deduct a single rental expense.
But, if you believe in the long-term returns on your building, you'll invest in new paint or new roofing. You might install new windows to keep the heat in. Our clients do these things to make their properties better and create an efficient use of tax dollars.
Instead of paying taxes on $1,000, you can pay taxes on $600, $700, or even $300. That's a couple of hundred dollars you saved, and it puts money back in your pocket.
Rental Investor Starter Kit
At Mynd Property Management, we manage residential properties in San Diego, the Bay Area, Seattle and 16 additional markets. Today, we're excited to talk about the tax benefits available when you invest in rental real estate.
Our CEO Doug Brien owns 12 buildings, all of which are managed by us. One of the critical components to his success and our success as a property management firm is that we can handle the tax liabilities and the tax benefits that come with owning rental real estate.
Today, we're sharing some of the lessons and best practices we have learned from hundreds of clients and our own founder's success, so you can make use of every rental property tax deduction you can use!
Take Advantage of Tax Reform Passed by the Trump Administration
The Tax Cuts and Jobs Act of 2017 (TCJA) added new tax benefits and deductions for real estate investors. Real estate has always been tax-efficient.
One new real estate tax deduction opportunity after 2019 is that you can take advantage of the Qualified Business Income Deduction (QBI), or Section 199A of the Internal Revenue Code. This new tax law allows 20% of your rental income to be immediately deducted from your taxes. So, regardless of what you earn, you get a 20% deduction right out of the gate.
Maintain Good Records
Keeping excellent records can set you up for success at tax time. Make sure you keep all your receipts. Organize what you spent on your building when you visit and what types of investments you made in your properties. It works to your benefit to be organized, and it's better for you at tax return time. Your accountant will love you, and your bottom line will benefit.
We have a proprietary system that captures as much information as possible about your building, right down to the unit level. We can work with your accountant to provide day-to-day tax information for easier tax preparation. Owners who do this are meticulous, highly organized, and good at keeping records. They save more money on their taxes than less organized owners. Ask your property management team how they stay organized.
Get Creative: Invest in Qualified Opportunity Zones
Qualified Opportunity Zones allow investors to get creative with managing their taxes. These Qualified Opportunity Zones are based on the premise that investing in low-income neighborhoods will improve buildings and make the community a better place for people to live.
Take the money you make on other rental properties or different investments and invest it in an Opportunity Zone. When you do this and follow a few rules, you can lower your tax liability by 15%. So, if you made $100 investing and put that money in a Qualified Opportunity Zone, you might pay taxes on only $85. That's a huge tax benefit.
Opportunity Zones also require you to invest in and improve the property. That's exciting because you'll have a beautiful building, and your whole neighborhood will benefit. You can also forgive any capital gains tax from that moment on. So, invest that $100, turn it into $200, and you pay zero taxes. There are lots of opportunities for leverage.
Other Tax Deductions You May Want to Consider
There are other benefits associated with owning investment real estate. If you don't live in the state that the property exists and you need to fly there to visit it, you can deduct your travel expenses. You can also deduct your landscaping bills and the cost of showing the building when you have a vacancy, among other things.
Here’s a partial list of 31 tax deductions real estate investors can take:
- Business Startup Costs
- Costs Incurred While Looking For New Property
- Homeowners Association Dues
- Interest Paid On Loans Or Credit Cards
- Internet and Cell Phone Plans
- Legal Fees for an Eviction
- Meals and Entertainment
- Ordinary and Necessary Advertising Expenses
- Petty Cash Expenses
- Preparing Documents
- Property Management Company Fees
- Rent for Equipment and Tools
- Subscriptions and Memberships
- Utilities Paid By The Landlord
Knowing how to choose the right legal entity for your real estate investment will allow you to enjoy more tax benefits.
- Liability Protection: Liability is when you’re held responsible for something under law.
- Perpetual Existence: Incorporation means your business won’t be affected if one of the owners dies or withdraws.
- Tax Advantages: New benefits become available to you once you're incorporated, and, in some cases, you can also make yourself less likely to be audited.
- Improved Business Perception: People will think more of your business if they see Inc.” “Co.” or “LLC” after your business’s name.
- Easier Management: Incorporation means your business is centralized, making it easier to run, particularly if you have a board of directors.
- Incorporation is Easy: Incorporation doesn’t take long and is even more affordable without a lawyer.
Capital Gains Tax Instead of Income Taxes
Capital gains are taxes you pay when you sell a property. They can be at a lower tax rate than your ordinary taxable income rate.
- Property held for one year or less can incur short-term capital gains taxes between 10% to 37% depending on your income tax bracket.
- Property held for a year and one day or more can be taxed between 0% and 20%, depending on your income tax bracket.
Aside from house-flipping and wholesaling, the most commonly used real estate strategies entail holding onto a home for more than a year, which means that, ultimately, you’ll pay fewer taxes if you sell your home than if that income was made by another means.
Depreciation is a tax write-off that makes investing in real estate more manageable.
Depreciation is applied to both property and improvements. Depreciation isn’t applied all at once, though, because the value of property and improvements extends beyond a single tax year. For this reason, depreciation is applied over the useful life of a property or improvement.
In real estate, “improvement” and “repair” are technical terms that refer to specific things.
Sometimes, it can be hard to distinguish between an improvement and a repair. For now, this distinction should suffice:
- Improvements: Add value to your property.
- Repairs: Return your property to its original condition.
A roof is a great place to appreciate this difference. Patching a hole in your roof is a repair, but replacing your roof is an improvement.
One thing to keep in mind is that you have to pay a tax on the amount you save because of depreciation. This tax is known as depreciation recapture. Depreciation recapture is applied whether or not you make use of depreciation. Meaning that even if you choose not to depreciate the cost of a purchase, you will be taxed as if you did.
However, if you sell at or below the depreciated value of your property, you don’t have to pay depreciation recapture. You can also avoid paying depreciation recapture if you do a 1031 exchange, also known as a Starker exchange.
A 1031 exchange allows you to defer paying capital gains taxes and depreciation recapture. How a 1031 exchange works is that you use the profits from selling one property to buy one or more properties of equal or greater value.
Time plays a significant role in the 1031 exchange. After you've sold your property, you have around 45 days to find replacement properties. After that, you have 180 days to complete the purchase of those properties.
If done correctly, a 1031 exchange can be a way for your heirs to avoid paying any deferred taxes upon your death. Rather than fund real estate into a trust, you can continue performing 1031 exchanges until your death. Your heirs will receive the property on a stepped-up basis, which means that the property will be treated as if its value is its fair market value at the time of death and not have to pay any deferred taxes. However, your heirs may have to pay estate taxes, so they should consult an estate lawyer.
100% Bonus Depreciation and Section 179 Deductions
Bonus depreciation and Section 179 deductions let you depreciate an eligible deductible expense right away in the year in which the purchase is put into service. Bonus depreciation used to only be 50%, but the TCJA bumped it up to 100%! However, the TCJA also set an expiration date on bonus depreciation. Starting in 2023, bonus depreciation will go down 20% each year until it’s entirely off the table in 2027, unless Congress chooses to act otherwise.
Purchases eligible for a Section 179 deduction can also be depreciated in the year they are purchased. While bonus depreciation can be applied even if a business is not profitable, Section 179 requires profitability to use. If your business made $20,000 and your purchase is $30,000, you can only apply Section 179 to $20,000. The remaining sum will have to be depreciated the next year.
One of the most powerful tools is cost-segregation analysis. It's a technical analysis that takes your building and breaks it into smaller pieces for depreciation. You'll look at the depreciation schedule for each piece. You might be able to pull forward some depreciation and shield more of your income so you can reinvest that money. Some of our clients get an extra $10,000 in tax-deductible expenses. Take your extra capital off the table and reinvest it!
No Payroll (FICA) Tax on Rental Income
FICA stands for the Federal Insurance Contributions Act. It's a tax on employees and employers that funds Social security and Medicare. FICA is known as a payroll tax because it comes out of people’s salaries. If you're self-employed, your FICA tax contribution is 15.3%. However, you don't pay FICA tax on rental income, which is significant savings! If your rental income is $100,000 per year, not paying FICA taxes saves you $15,300.
No Taxes on Cash-Out Refinance Money
Refinancing is when you get a new loan with more accommodating terms than your old loan.
Cash-out refinancing is when you get a loan for more than your debt value. These funds can be used however you want, and that money is not taxed!
This makes popular investment strategies like BURL and BRRR more manageable.
- BRRR stands for “buy, rehab, rent, refinance, repeat.” It’s exactly what it sounds like. You buy a property, rehab it, rent it, refinance it, and then use the money from your cash-out refinance plus whatever you’ve saved up to repeat the process.
- BURL stands for “buy utility rent luxury.” To appreciate this strategy, you need to know how cap rate works. Cap rate is the measure of how long it takes for a property to pay for itself and begin to make a profit expressed as a percentage. A low cap rate is considered low risk because it’s less likely to stop generating income, while a high cap rate is considered riskier because it’s more likely to stop generating income.
The idea behind BURL is that you buy utility because it’s got a low cap rate, so you can afford to rent luxury because it has a high cap rate. Why would you do that? Because the luxury property could experience greater appreciation over time, making the risk worth it!
Flipping and rehabbing is not the same, but the live-in flip investment strategy exists somewhere between the two. You could end up paying zero capital gains taxes on a property that earns upwards of $250,000 for single filers and $500,000 for a married couple filing jointly. Qualifying for a Section 121 exclusion means:
- You have to live in the property: It must be your primary residence.
- You have to own the property: you had to have lived in it for two out of the five years that precede the sale.
So, what does a live-in flip look like?
It means you live in the house while adding improvements that add value to your property. Your changes can even be made with easy rental turnover management and attracting high-quality tenants in mind! You just have to be able to live in a home that’s undergoing repair.
If you attempt a live-in flip, but something comes up that requires you to move before you’ve lived there for two years, you can still qualify for partial exclusion from capital gains taxes, depending on the reason for your move.
- Job relocation
- Change in Health
- Military deployment
- Unforeseen circumstances
Check with a tax professional if you find yourself having to move early.
Investing in Real Estate with a Self-Directed IRA (SDIRA)
Knowing how to invest in real estate with a self-directed IRA (SDIRA) allows you to enjoy all the tax relief that comes from investing in real estate along with all the tax benefits of an IRA. There are two types of SDIRAs:
- Custodian Managed: An account holder directs a custodian to make and manage real estate investments.
- Self-managed: Also known as a checkbook controlled, this entails opening a limited liability company (LLC) to make and manage the investments yourself.
As with a 401(k), your taxes will be taken out at the time of your withdrawal. You can also choose a Roth SDIRA, in which case your taxes will be taken out when you make your deposits. If you’re investing in real estate, a Roth SDIRA can be particularly beneficial if your property experiences significant appreciation.
Whichever route you go, purchases of real estate can be funded by money outside of the IRA, but any operating expenses must be covered by money from the IRA. If you’re going the self-managed route, you can partner with others to help fund purchases. You can also take out a non-recourse loan, a loan that uses your property as collateral. That’s important because if, for whatever reason, you end up having to default on the loan, you lose your money, but your IRA remains untouched.
The reason people choose to have their SDIRAs managed professionally is because there are so many rules to follow when it comes to managing an IRA. If you take the wrong step, it can cost you big time!
Done correctly, using your SDIRA will make you a more resilient investor because of diversification, especially if the real estate you invest in is also geographically diverse. Remember, don't keep all your eggs in one basket, and don't keep all those baskets in the same box!
Measure Everything You Do
If you want to be tax-efficient, you need to have a lot of data on your property. Track the last time you put in a new tub, and make sure you know the old tub model. Document what kind of roof you have. At Mynd, we have built a system to capture all of this. We're excited about it because it helps our investment clients find more value for their building, and they can do their taxes a little smarter.
Talk to a Tax Professional About Your Rental Properties
At Mynd, we love talking about what's best for your property and the benefits of investing in real estate. We aren't tax professionals, but we see many tax benefits for the clients we currently serve, and we're happy to share what we know. We're here to communicate with you and your tax professional, so contact us today.
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