5 Tax Strategies For Real Estate Investors

Last Updated: October 12, 2019
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By taking advantage of these diverse tax benefits of investing in real estate, you can have more legitimate take-home income instead of giving most of them to the government.

Investing in real estate is one of the proven ways to best develop wealth and enhance your cash flow. Aside from getting a monthly rental income, there are also some potentially significant tax benefits.

The good news is that the new 2019 tax code has some awesome provisions to help real estate investors retain more income in their pockets.

Real Estate Tax Benefits

In a nutshell, here are the most important tax benefits for real estate investors:

  • Deductions.  This is one of the biggest real estate tax benefits that are available for investors. These tax write-offs, which are often applicable for rental properties, will include costs that have to do with mortgage interest, property tax, operating expenses, depreciation, and repairs.
  • 1031 Exchanges. If you are a real estate investor, you can use a tool in the tax code that they call as a “1031 Exchange”. This tool lets you defer any profits that you make on the sale of your real property if you purchase another similar property of equal or higher value.
  • Capital Gains. Investors should pay capital gains tax on the real estate investment property if they don’t reinvest the profit they realized on the sale. This also applies if they don’t offset it with other losses. Capital gains on a rental property that you sell could go as high as 20% of the profit that you realize depending on your tax bracket. But as long as you own the property, you don’t have to pay capital gains tax. However, when you sell a real estate investment property for a profit, that’s the time you have to give the government its share.
  • Depreciation. Another huge tax break that’s available to real properties is depreciation. Through this provision, you can recover the cost of an income-producing property via yearly tax deductions. The IRS defines depreciation deduction as an allowance for exhaustion or wear and tear. There are three factors that decide how much an investor can deduct each year in depreciation. They are:
    • The value of the property (How much is the property worth?)
    • The recovery period for the property (How long is its estimated useful life?)
    • The depreciation method they are using to account for it. (Are you using the straight-line method or another method?)
  • Appreciation. When you decide to buy and hold an investment property for a longer period, your net worth could grow with you having to pay taxes on the increase. When you sell any piece of real estate, it exposes you to a lot of expenses: transaction fees, commissions, and taxes. You can avoid paying these expenses and taxes while letting your real estate appreciate.
  • FICA. For passive income investors, your rental income is not subject to social security and Medicare taxes (aka FICA).

5 Tax Tips For Real Estate Investors

Here is a list of the best tax tips for real estate investors:

1. Get Organized

If you’re serious about getting back any amount of money you deserve this tax season, the first important step is to become very organized. In case you earn a lot from your real estate deals and become subject for audit by the IRS, you should know that they would want to see all your receipts, every document and each piece of proof that relates to your business transactions.

If you bought, sold or refinance any real estate during the year, the escrow company will have sent you a HUD-1 Settlement Statement. This is a standard government real estate final closing statement that itemizes all the charges that they imposed upon the borrower and the seller. Make sure that you include this document when you prepare your current-year tax documents because it contains information necessary to the tax return. You can use online tools (such as Quickbooks) to manage your expenses in a more orderly fashion and have access to their records easily.

2. Hold Properties For More Than a Year

When you watch some TV shows, you might think that flipping properties in a matter of weeks is a glamorous and rewarding thing to do but in reality, a large portion of your profits will go straight to the IRS. The way to lessen the tax component is to hold a property for more than a year.

The IRS considers any investment profit as capital gains and they will tax you based on your income and how long you’ve owned the property.

If you hold an asset for less than 12 months, the IRS will apply the income tax rate (which can run up to as high as 35%). However, if you keep a property for more than a year, only the long-term capital gains taxes will apply and this normally just reaches a maximum of 15 percent.

Let’s look at two scenarios. In the first one, you earn $100,000 in a year but $40,000 of this comes from short-term investments. In the second one, you earn $100,000 but $40,000 comes from long-term investments. This is how it would play out:

  • Scenario 1 with short-term investments: Income tax computation will be $100,000 x 28%. The federal tax due will be $28,000.
  • Scenario 2 with long-term investments: Income tax computation will be [$60,000 x .28] + {40,000 x .15]. The federal tax due will be $22,800.

You see, waiting for at least a year increases the amount of your take-home income by $5,300. That’s a no-brainer in our humble opinion.

3. Know The Pros And Cons Of Being a Business

  • Be prepared for business taxes

If you wrapped up several real estate transactions in a year, the IRS might consider them business or trade rather than an investment strategy, so prepare yourself.

While they treat everything on a case-to-case basis, if you’re earning more than half of your total income from real estate, your earnings will change from “capital gains” to a means of producing regular income. This classification will subject you to ordinary income tax rates (which are usually higher). Also, you should pay an additional 15.3% in taxes for being self-employed.

  • Take advantage of deductions

Not many people know that deductions are big real estate tax benefits that investors can turn to. These tax write-offs that are often related to rental properties include costs that come with mortgage interest, property tax, operating expenses, professional fees, depreciation, travel, and car expenses and repairs.

4. Hire a CPA

We will emphasize this tip as often as we can. Real estate investors have the opportunity to save a lot of money during tax season, but it is not very easy and simple to do so. As you look at the many deductions and possible tax provisions that could work to your advantage, a Certified Public Accountant (CPA) can use his or her expertise to help you get back every cent that you legitimately deserve.

You cannot skip the services of a trained professional during tax time and it should be someone with knowledge about your field of expertise or industry. You can ask other investors in the market to find a CPA who has good practical knowledge about real estate deductions. Yes, the services of a CPA will cost you money but the amount of money you’ll get in return will be worth the expense.

While you may succumb to the temptation to try and save some money by going at it using DIY tax software, it’s not worth the risk. Each situation is different. It will be worth the time and money to consult with your accountant or tax advisor to make sure you’re taking the best directions for your deductions. And allocate enough time for this – consult your tax professional long before the year’s end and not when the tax season is at its peak.

5. Take Advantage Of Depreciation

The most popular depreciation method that investors use is the Modified Accelerated Cost Recovery System (MACRS). The IRS allows investors to deduct depreciation expense on a residential property using a factor of 27 and one-half years and 39 years for commercial real estate. Depreciation allows the owner to recognize a net loss on an investment property due to wear and tear even if the property is productively generating a positive cash flow.

This means that for each year, you can deduct the amount of the value of your “improvements” (capital expenditures on the property like major property improvements/renovations such as replacing the roof or finishing the basement). You compute it by dividing the total cost by 27.5 years and then deducting the resulting amount from ordinary taxable income for the year.

Here is a simple example:

  • Scenario #1 (without the depreciation expense):

For a $10,000 taxable rental income, multiply it by 25% (federal income tax rate). You’ll end up owing $2,500 in taxes.

  • Scenario #2 (with depreciation expense):

For $10,000 rental income minus a $7,000 depreciation expense, you’ll get $3,000 net taxable rental income.

Tax computation would be $3,000 x 25% federal income tax rate or just a $1,200 tax. You can have a tax savings of ($2,500 minus $1,200) $1,300.

The higher your tax rate, the more taxes you would save when you take advantage of depreciation expense.

Understand the difference Between Short and Long-Term Investments

Before you jump into the tax-saving game, you should separate your long and short-term investments. To know which is which, the short-term investments are those that you’ve held for one year or less. The rest are the long-term investments.

For example, you can classify wholesaling, rehabbing, and flipping fall under the short-term investment category while buy and hold properties normally fall under long-term investments. Ask your CPA to help you properly sort your investments into their correct categories.

Use Your Investment Property as Your Primary Residence

There is a real estate strategy known as the Live-in Flip that offers you a bountiful tax exemption. If you turn your investment property into a primary residence, you can totally avoid capital gains tax.

In order to avail of this provision, you must spend 2 years (or 730 days) living in your home for the last five years. The time of occupancy doesn’t have to be sequential. Once you’ve established the sufficient amount of residency, you can sell the home and realize as much as $250,000 in capital gains (or $500,000 if you’re married and filing jointly) without having to pay taxes on it.

Understand Your Partnership Or LLC Agreement

Do you have a good understanding of your partnership or LLC operating agreement? Do you know if your allocations among the members would have “substantial economic effect”? Alo, do you understand what a qualified income offset provision is? What about minimum gain?

When it comes to real estate matters, the operating agreements normally address these and other critical tax issues. Most likely, your agreement provides for such issues, so it is important that you are familiar with them inside out.

Exchange Properties For Tax-Free Growth

One other way to skip capital gains tax (and also depreciation recapture tax) is by doing a section 1031 tax-free exchange. This comes from Section 1031 of the U.S. tax code. A 1031 exchange enables you to trade one property for another without having to pay taxes. But you should qualify as an investor (not a dealer who flips house or other real estate businessmen) and you must follow the government’s specific guidelines.

Important:  Note that you can only exchange real property (real estate building and land).

Why go to this route? Well, you can use 100% of the profits from the sale to reinvest in another property. You then take advantage of the growth and compounding of your investments to the full. For example, let’s say you sell a property for $250,000 and don’t avail of a 1031 exchange.

You might end up paying $30,000 in capital gain and depreciation recapture taxes. If you avail of a 1031 exchange, the $30,000 would remain invested in your assets. Assuming that you’re getting a 3% return for it, in the next 15 years, your $30,000 would grow to more than $47,000!