Are you a tax-savvy investor who is looking for more tax benefits? You’ve come to the right place! Investing in real estate is one of the most effective methods to decrease your taxes. We’ll discuss how depreciation may help you save money, as well as why some people invest just for the tax perks.
Individuals invest to expand their financial assets. Individuals learn to leverage their limited monetary resources to various investment vehicles with the potential for significant gains, whether they are investing in stocks, bonds, or real estate. However, one of the most important and often overlooked influences on an investor’s rate of return is taxes.
Taxes can reduce the earnings of any investment, posing a risk to anyone’s financial goals. While real estate investing is sometimes considered one of the best methods to increase wealth and minimize taxes, it is not exempt from taxation. If you want to make significant cuts to your taxes, you’ll need to employ some management techniques.
To help you achieve better long-term results, we’ve outlined the finest strategies to minimize your taxes as a real estate investor.
Utilize The Depreciation Method
Real estate depreciation is a deduction that allows property owners to calculate the average wear and tear on an asset over a specific period. Because there’s no way to know how long a home will last, the Internal Revenue Service (IRS) established the duration of such properties.
A home is depreciated at a rate of 27.5 years. Commercial real estate must be depreciated over 39 years. If you bought a home for $250,000, you could deduct $9,090 each year in depreciation on your taxes ($250,000 divided by 27.5). Depreciating capital expenditures like installing a new roof or rebuilding a kitchen is also possible.
However, you cannot depreciate repairs that are important to keep the property operational. It’s also worth noting that for your investment property to be depreciated, it must be available to rent. The property must be available to rent all year for you to claim full depreciation for a full year.
The depreciation recapture is another important factor to consider. You’ll have to pay taxes on the profit you make from selling a depreciated rental property once you do so. If you don’t think about selling the home, though, you won’t have to worry about such taxes.
How powerful is depreciation…really?
Let’s take a look at this concept in more depth. For example, suppose you just acquired a new laptop. That machine is wonderful on the first day. However, over time, the keyboard becomes sticky, the processor slows down, and the battery only lasts a few minutes at most. The entire thing will ultimately fail and be of little or no value. This is the essence of depreciation.
The IRS, in essence, understands that if the property is continuously utilized and you do nothing to improve it over time, natural wear and tear will wreak havoc on it, making it unusable (much like when your laptop eventually dies).
Each asset has a different life span. You wouldn’t expect a laptop to survive more than a few years. On the other hand, you would anticipate that a home would remain standing for many years or even decades after its construction.
The IRS permits you to depreciate the value of residential property over 27.5 years.
Only the property itself is eligible for depreciation benefits, not the land. The IRS is wise enough to recognize that the land will still be around in 27.5 years and will still be worth the same or more.
Here’s an example
Let’s assume you paid $1 million for a property. Assume the site is valued at $175,000 and the structure is worth $825,000.
With straight-line depreciation (the most basic type), you can deduct an equal amount of that $825,000 each year for 27.5 years. That implies you may deduct $30,000 every year due to depletion ($30,000 x 27.5 years = $825,000).
The significance of this is that, in the example given above, if you earn $5,000 in cash-on-cash returns (i.e., cash flow) on a property during the first year, you can keep all of it tax-deferred (i.e., without having to pay taxes on it until the property is sold.
Yes, really. *
*Disclaimer: This is dependent on your tax status. Please contact your CPA for further information.
Tax deductions reduce your taxable income, so a $30,000 depreciation expense appears to result in a loss on paper. In reality, you made $5,000 because of it.
Furthermore, properties acquired after September 27, 2017, are eligible for bonus depreciation, which can significantly enhance the tax benefits in the first year. This is why depreciation is so beneficial.
Give Live-In Flips A Shot
You live in your investment house for a certain length of time while you make improvements with a live-in flip. You are not required to pay capital gains taxes if you sell the property after living in it for at least two of the past five years. Like all other tax breaks, live-in flipping has restrictions.
The tax exclusion limit for single people is $250,000, whereas it’s $500,000 for married couples. Furthermore, unless you’re active-duty military, obligated to relocate for work, or have medical issues, you can only do one live-in flip every two years to save money on your taxes.
In some instances, live-in flipping may not be the greatest option if you wish to stay in your house for an extended amount of time. You would have to relocate every two years using this real estate investing strategy. However, if you enjoy home renovations and want to make money without paying taxes, it may be a fun way to do so. You just have to be careful not to pay too much so that you aren’t losing more money on the house’s upgrades.
Try Offering Seller Financing
Another technique to save money on your taxes is to provide seller financing to the buyer of your property. You’re making an installment sale when you sell a home with seller financing. The buyer makes a down payment and then pays down the remaining balance regularly throughout the term of the contract.
Instead of paying a large sum of money in one year, you only have to pay income taxes on the down payment and principle that the buyer pays you. As a result, it allows you to realize your profit and spread out the tax over many years. Your tax burden is decreased since you’ll receive a much smaller income each year. However, seller financing comes with a risk: the buyer may default on the loan.
That is why you should consider whether it’s worth giving up the lump sum you could get from traditional selling for the extra tax benefits. However, keep in mind that, regardless of how much capital gains taxes you pay, you may earn more interest from your buyer if you make an installment sale.
Make the Most of Your Tax Deductions
Investors may benefit from several tax deductions. If you want to lower your tax rate, taking advantage of such tax write-offs will be quite beneficial. The following are a few of the deductions that a real estate investor may take advantage of:
As an investor, you may deduct the interest you pay on your mortgage, whether it’s on your main or secondary home. If you utilized money from a loan secured by a mortgage for your business, you could also deduct that interest. This deduction applies to house purchases, home equity loans, and lines of credit.
There are state, local, and property taxes that may be subtracted from your taxable income. You can claim tax deductions on your home’s property taxes. However, you can only benefit from such a situation if you owned the property and utilized it for personal purposes. If you’re searching for more ways to save money on your property taxes, consider hiring a property tax consultancy.
Routine Maintenance Costs
You may deduct the expenses associated with regular maintenance activities throughout the year they occur. However, routine maintenance is defined by the IRS as maintaining your property in good working order. As a result, it includes only repairs or upkeep that do not improve the value of the property or extend its usefulness.
These are just a few of the deductions that may be taken while investing in real estate. You may discover and claim additional deductions to reduce your tax bill, as long as you’re itemizing your deductions. If you take the standard deduction, on the other hand, itemized deductions don’t help.
Use 20% Pass-Through Deduction
The Tax Cuts and Jobs Act of 2017 allows individuals who generate qualified business income to take advantage of a pass-through deduction. It implies that you may deduct an extra 20% of your real estate investing business profits from your taxable income.
For example, let’s assume you own and manage a rental property with an income of $40,000. You might be able to eliminate $8,000 from your taxes or 20% of the net income after pass-through deductions. However, you may have to consider additional factors, so it’s recommended that you contact a professional tax adviser to see whether you qualify.
How To Reduce Your Taxes As A Real Estate Investor
Real estate is one of the most effective methods to protect and increase wealth. However, like with other investments, the amount you pay in taxes may have an impact on your earnings. The key is to be proactive about preparing your taxes and learning about real estate investing’s tax benefits.
Some of the many ways you can potentially reduce the amount you pay in taxes are:
- Accelerated Depreciation
- Live-In Flips
- Seller Financing
- Mortgage Interest Deductions
- Property Tax Deductions
- Routine Maintenance Deductions
- 20% Pass-Through Deduction
Real estate investing can be a tax-efficient way to make money. However, tax implications are an integral part of the process. That is why real estate investors need to learn about deductions they may qualify for when dealing with their investments. Keep in mind that you should always consult with tax advisers before taking tax deductions for your real estate investments.