Part I: The Tax Benefits of Real Estate Investing
When evaluating an investment, tax savings are commonly overlooked. While it may not jump out at first when calculating cap rates or cash on cash, taxes play a crucial role in making the decision to jump into real estate investing.
There are two points of income taxation for an investment property. Taxes are paid on the rental income earned and then on any realized gains at the point of sale.
In the first part of our series on real estate taxes, we will cover the most relevant to investors in the short term: deductions. In later installments we will cover dispositions, 1031 exchanges and other important topics to fully understand how taxes & real estate go well together.
As far as tax benefits go, deductions are by far the biggest advantage. When reporting rental income, investors are likely to report these items on Schedule E on their tax return. Here, rental income and expenses are listed to arrive at a net gain or loss which then goes to determining taxable income. The IRS has provided guidelines on what expenses qualify for deductions.
Here are the most relevant and largest deductions available:
- Property taxes paid to a local/state government
- Loan costs and loan interest — origination fees and the interest portion of the monthly payment are fully deductible
- Insurance premiums
- Maintenance and repairs — These are expenses to keep the home in “rentable” condition. They are not capital expenditures. We will discuss those below in the depreciation section
- Office space — this could be a spare bedroom used! Office items are included as well
- Pre-rental expenses and vacant property expenses — Investors can deduct expenses for managing the property before it is rented or while it is vacant (in turn for a new tenant)
The full list of deductions can be found here under “types of expenses”. We recommend consulting with your tax professional if you have any questions.
Depreciation allows investors to deduct the costs of buying and improving a property over its useful life, lowering taxable income in the process. Depreciation can begin once the property is “rent ready”. The key point to remember is that this deduction is spread across the life of the asset — the IRS sets the life of residential property at 27.5 years for depreciation purposes.
Rather than get into the nitty gritty of calculating depreciation , here is a potential cost benefit:
Depreciation amount for the year — $3,000
Investor’s tax bracket results in a 22% income tax rate
Savings are calculated as $3,000 * 0.22 = $660
Depreciation is one of the top advantages of owning real estate. However, if the investment property is sold, the owner will have to deduct their depreciation from the original purchase price to arrive at their cost basis. In a later edition of this series, we will go into more detail about investment dispositions and how the 1031 Exchange is wonderful for investors.
Real estate offers tax advantages that are not often available to the individual investor. When evaluating an investment opportunity, it is important to factor in the potential tax savings rental real estate can provide, especially if you are in the higher tax brackets. I will be visiting more topics in the future and look forward to sharing more information!
Note: This article is published for informational and educational purposes only. Awning does not provide tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.