Are you taking full advantage of the tax benefits of real estate investing? If not, you should and here’s why. Generally, most people venture into real estate investments with two things in mind – wealth development and improving their cash flow.
For years the property industry has proven to be very lucrative, especially in key prime areas. What’s more, investment properties come with multiple ways to make an extra dollar including:
- Raising the rent
- Exploring tax benefits
- Minimizing vacancies
- Adding convenience services
- Minimizing your expenses
- Using coin-operated appliances and so on
But, out of all these options, tax benefits are the best and safest because they don’t affect your tenants directly.
Basically, you need to know what your tax break options are and how to take advantage of each of these.
Any property investor will tell you that real estate taxation constitutes a substantial part of their expenses. Evidently, the biggest way to maximize profits is by minimizing your expenses.
Therefore, if you are asking yourself; how can I make more money from my real estate investment through tax benefits? This post details a few workarounds you can use to lessen your tax burden.
A Few Popular Tax Benefits for Real Estate Investors
Let’s face it, owning an investment property means paying thousands of dollars in taxes annually. But, what if there was a way to cut down on these expenses?
Here are a few common tax benefits you can use to increase your rental income.
1. Real Estate Depreciation Tax
Despite rarely losing value, investment properties are assets that depreciate over time due to wear and tear. It is because of this that the IRS allows rental property owners to deduct a depreciation expense from their gross rental income.
Anyone who’s well-versed in matters relating to depreciation – and how it relates to taxes will tell you that it offers property investors a huge tax shelter.
So, you may be wondering how does rental property depreciation work? Or, how can depreciation reduce your real estate’s income tax?
Well, the IRS allows real estate investors to take a tax deduction based on the calculated decrease of the property’s value. For residential rental properties it is based on 27.5 years and for commercial properties, it is over a period of 39 years.
This means that every year during that period of time you get to claim on your taxes the depreciation of your investment property. Allowing investors to write off their edifice and preservation costs over the allowed period of time.
So, to determine your property’s yearly allowable depreciation deductions, you have to divide the buildings worth by the number of years the IRS states. Which is either 27.5 or 39 years. It is important to remember that the land value is not subject to depreciation, only the building’s value.
So, to start, a residential rental property valued at $100,000 will be allowed a depreciation expense of $3636 ($100,000/27.5) annually.
Basically, depreciation can be determined using:
- A property’s actual worth.
- The depreciation method in use. Most people use the Modified Accelerated Cost Recovery System (MACRS) depreciation method nowadays.
- And lastly, its recovery period (27.5 or 39 years)
Once you factor in the depreciation amount, it easy to see how your tax burden will lighten.
Hypothetically, if the property mentioned above generates an annual rental income of $50,000 and has recurrent expenses of about $15,000, here’s how you can calculate your total taxes owed:
- Taxes owed = (gross rental income – total expenses) x federal income tax rate
- Total expenses = all deductions + depreciation expenses => $15,000 + $3636 =$18,636
- Therefore, total taxes owed will be = ($50,000 – $18,636) x 25% = $7,841
- If you don’t include the depreciation expense, you’d pay more tax as shown below:
Taxes owed without depreciation = ($50,000 – $15,000) x 25% = $8,750
Can you spot the difference?
Obviously, when dealing with more than one rental property, your real estate depreciation tax break can be much greater.
2. Real Estate Investment Tax Deductions
Aside from depreciation, there are many other expenses that a property owner can deduct from their gross taxable income. There are almost more tax benefits involves in real estate investing than any other form of investment.
Basically, a deduction is a write-off of an expense arising from the management and maintenance of a rental property.
Generally, rental property tax deductions may include expenses like:
- Insurance premiums
- Mortgage interest
- Property management expenses
- Repair and maintenance costs
- Utility expenses
- Advertisement costs and so on.
Basically, any expense that doesn’t raise the property’s worth is considered a deductible expense. Make sure to take advantage of all tax deductions available to you as a property investor to help increase your annual rental income.
3. 1031 Exchange
Section 1031 of the Internal Revenue Code allows rental property owners to swap their property for one or more properties with little or no tax obligation.
Obviously, this tax benefit comes with its own set of conditions; all of which have to be met strictly.
For example, to be eligible, the following conditions must be met:
- The new property must be an investment or commercial property.
- Both properties must be “like kind.” This means that you cannot swap an investment property for a REIT (Real Estate Investment Trust).
- Moreover, the new property must be equal or greater in value than the old one.
- Any cash transacted during the acquisition may be subject to taxation if it’s not considered “like kind.”
- Also, the new Tax Cuts and Jobs Act stipulates that a 1031 exchange cannot be used properties held for personal use.
The best part about these tax benefits is that it allows you to pass on your capital gains to your new property.
In conclusion, these are just a few of the many tax benefits that exist today. Knowing a bit about each of them and how to exploit their benefits can reduce your annual tax obligation by thousands of dollars.