Real Estate Investing Tax Benefits

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. Deductions and depreciation are the best way to manage.

As far as tax benefits go, deductions are by far the biggest advantage of real estate investing. 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:

  1. Property taxes paid to a local/state government
  2. Loan costs and loan interest — origination fees and the interest portion of the monthly payment are fully deductible
  3. Insurance premiums
  4. 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
  5. Office space — this could be a spare bedroom used! Office items are included as well
  6. 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

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!

Why should an investor care about 1031 exchanges? Referring back to Part I, depreciation is an important tax savings tool real estate investors use on a yearly basis. However, when it comes time to dispose of depreciated real estate, the total depreciated amount is subtracted from the original purchase price. For example:

Original purchase: $100,000
10 year depreciation amount: $10,000
New Cost Basis: $90,000
Sale Price: $125,000
Net Gain: $35,000

*Numbers are simple for an illustration, please refer to Part I for depreciation calculations

1031 Exchanges offer real estate investors an opportunity to defer these gains. The 1031 Exchange gets its name from Section 1031 of the tax code shown here:

Nonrecognition of gain or loss from exchanges solely in kind

(1)In general
No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.

Tax jargon aside, the IRS allows investors to defer taxable gains on property sales if the proceeds are used to buy a “like kind” property.

What is “like kind”?

Like kind is defined according to its nature or characteristics, not its quality or grade. There is a broad range of exchangeable real property. You can exchange vacant land for a single family rental but you cannot exchange real estate for artwork. After the exchange is deemed to be “like kind”, the investor utilizing 1031 must also ensure that both the relinquished and the replacement properties are held for investment purposes or for productive use in a trade or business.

Next, the investor has a few different ways to take advantage of the 1031 exchange. It does not necessarily have to be a 1 for 1 property exchange.

In order to make the most of a 1031 exchange, real estate investors should identify a replacement property — or properties — that are of equal or greater value to the property being sold.

There are three ways to do this:

  • Identify up to three properties regardless of their value, or
  • Identify unlimited properties as long as the combined value doesn’t exceed 200% of the property being replaced, or
  • Identify unlimited properties as long as the properties acquired are valued at 95% or more of the property being replaced

Advanced planning of a 1031 exchange is the key to success. An investor has 45 days to find a property after selling the original investment. Therefore, investors usually have their strategy lined up so they can execute within that time frame. Failure to execute will result in no tax deferral on the original investment.

A 1031 exchange will not apply to all investors and can get complex. We recommend consulting a qualified professional to plan a potential exchange. Awning is here to help identify properties once a plan is laid out and we have the tools and resources to ensure you find a property within the 45 day window.

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.

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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.

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