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October 21, 2019

Tax Benefits of Real Estate Investing

Real estate investing provides numerous benefits for those looking to diversify their portfolio. With many of the wealthiest Americans placing a substantial amount of their assets in real estate, it should be of no surprise that it is a great way to build wealth. Not only does real estate enjoy great returns, but there are also several tax benefits real estate investors can take advantage of.

  • Numerous business write-offs
  • Self-Employment and FICA Taxes are not paid on rental income
  • Depreciation
  • Avoid capital gains taxes
  • REITs provide the biggest tax benefit of all

Write off business expenses

As far as the Internal Revenue Service (IRS) is concerned, real estate investments are treated as a business. Operating expenses such as property management, maintenance, advertising, insurance, etc. can all be written off against positive cash flow. This applies not only to large commercial properties but smaller single-family investments as well.  

Self-Employment and FICA Taxes are not paid on rental income

While income earned from real estate investing is taxed at the applicable tax rate for the individual filer, certain taxes are not applied. As many American workers may notice on their paystubs, FICA taxes (Social Security, Medicare, etc.) are taken out of employee checks and is split between the employer and employee equally. The total is 15.3% of gross income, with 7.65% coming from both the employee and employer. Self-employed individuals must pay the entire amount.

Passive income sources, such as real estate investments, are not subjected to the FICA taxes. This can result in significant savings at tax time.

Depreciation

Depreciation is a commonly known benefit amongst real estate investors. It will show up on the tax filings of anyone who owns investment properties and is a great tax benefit. In short, depreciation is the Internal Revenue Service determining that the property you are gaining a benefit from is depreciating in value. This can be written off as an operating expense in the same way you would write off advertising, maintenance, etc. 

The IRS determines that the useful life of a commercial property is 39 years. For residential property, it is 27.5 years. So, to calculate the amount of depreciation allowed for a given year, divide the purchase price of the property by either 39 or 27.5, depending on the property classification, to get the amount you could write off during a single tax year. For example, if the purchase price of a piece of commercial real estate is $300,000, you would divide that by 39 to get a yearly depreciation amount of $7,692.30 ($300,000 ÷ 39 = $7,692.30).

For many, the tax benefits are significant, allowing even those who have positive cash flow to show a loss at tax time.

But, beware. When you sell the property, depreciation recapture will come into play. Assuming the property did not actually decrease in value, you will be expected to repay the amount of money claimed over the course of ownership. Some ask if they can just not claim depreciation. In short, the answer is no. The IRS assumes you will claim it, so it’s better to just do that.

There are ways to avoid repaying the tax benefits of writing off deprecation, bringing us to our next topic.

Avoiding capital gains taxes – 1031 exchanges

If you purchase an investment property and it increases in value, you will be responsible for paying capital gains taxes on the profit. This, much like depreciation recapture, is a tax liability that all investors face when their investment yields return at resale.

Luckily, there is a way to avoid paying taxes on the profit. From the date of sale, you have 180 days to roll your entire proceeds into the purchase of a larger property and delay the requirement to pay taxes on the profit. This is commonly referred to as trading up since you can purchase a larger property, one in which will probably generate more income, and allow for the continued write off of depreciation, operating expenses, etc. while avoiding paying additional income taxes on the property.

You could, in a sense, trade-up forever and never pay income taxes on your commercial real estate. When it’s all said and done you may eventually leave the property to your heirs and no one will ever pay capital gains on the investment. At the time of your death, they will receive the property valued at the fair market price, eliminating the capital gains and depreciation recapture accumulated over your lifetime.

Real Estate Investment Trusts

Real Estate Investment Trusts (REITs) have many benefits for investors. They are the perfect avenue for smaller investors to realize the high returns from real estate properties without having to come up with large amounts of money. They also eliminate the hassle of having to worry about depreciation recapture, capital gains, financing, complicated leases, etc.

REITs allow investors to purchase shares in income-producing property, giving them the opportunity to earn dividends from rental income without having buy, finance or manage the property themselves. The tax benefits of owning the property (operating expenses, depreciation, etc.) are applied to the investment property and are passed on to the investor in the form of dividends but the individual investor does not have to worry about the management of it.

The current administration signed into law tax provisions that benefited many sectors of the economy. One of which deals directly with pass-through businesses, such as REITs. A pass-through business is one where the income generated by the business passes-through an intermediary and on to the investor. As such, corporate taxes are avoided, and the tax liability is in the hands of the individual share/unit holder to be taxed at their marginal tax rate.

The avoidance of the corporate tax eliminates double taxation as the income generated is only taxed one time.

The additional benefit comes from President Trump’s tax bill signed in 2017 that allows for the pass-through deduction. The pass-through deduction allows investors to deduct up to 20% of their dividends from their income for tax purposes. These savings can be in the hundreds or thousands of dollars a year for investors, depending on the dividends earned.

Real estate investing is a great way to accumulate wealth and achieve your financial goals. As with any investment, there is risk, but with a sound strategy, you could join the many Americans who benefit from real estate investments and are seeing additional benefits come tax time.