Do you know everything you need to know about tax benefits? Investment properties, like residential properties, have their fair share of tax breaks. As an investor, it is in your best interest to have access to all the information.
Learn how to get the most out of your investment by reading up on your tax break options. Doing so can save you thousands of dollars on your rental income tax, each year.
The Best Tax Benefits for Real Estate Investors
1. Tax Deductions
Real estate investment tax deductions are the most important of all tax benefits.
Now, you may be wondering; what are these real estate investment tax deductions? What exactly are you allowed to write-off from your tax burden?
Well, in most states, investment property tax write-offs may include:
- All expenses incurred to manage and maintain your rental property
- Mortgage interests
- Insurance premiums
- Marketing expenses
- Repair costs
- And lastly, utilities
However, repair costs that increase the value of your property cannot be included in your tax write-offs. Only repairs that help with the maintenance and integrity of the rental can be incorporated.
2. Real Estate Depreciation Tax
You may be wondering how depreciation applies to residential properties when in reality their value is always increasing.
According to the IRS, properties also depreciate in value - just like other types of assets. And if you are well-versed with tax benefits, you know that depreciation offers you a massive real estate tax shelter.
How can you use real estate depreciation to your advantage?
According to the IRS, property owners can write-off depreciation expenses for 27.5 or 39 years; for residential and commercial properties, respectively. These depreciation expenses are a result of the “wear and tear” or “exhaustion” of the investment property.
So, how do I calculate depreciation?
Well, it is determined using the following items:
- The property’s value
- Gross rental income
- The property’s recovery period
- The appropriate depreciation method
The most common depreciation method is the Modified Accelerated Cost Recovery System (MACRS).
MACRS method calculates depreciation by subtracting the property’s depreciation, and other expenses, from its total income and then multiplies the result with the taxable federal income tax.
(Gross income – Depreciation expenses) * Federal income tax = Total tax owed
If you own a $200,000 rental property, you can calculate your annual depreciation by dividing $200,000 by 27.5. This means that your property depreciates by $7,273 annually.
This also means that you are eligible for a $7,273 tax break each year. Amazing, right?
Now, if the property generates $50,000 in rental income and has about $20,000 in recurring expenses, here’s how you calculate the tax owed:
Total expenses incurred = $20,000 + $7,273 = $27,273
Taxable income = $50,000 - $27,273 = $22,727
Taxes owed with depreciation = $22,727 X 25% (federal income tax) = $5,682
Taxes owed without depreciation = ($50,000 - $20,000) X 25% = $7,500
You’d be saving $1,818 annually if you take advantage of your depreciation tax benefit.
3. The 1031 Exchange Tax Benefit
As stipulated under Section 1031 of the Internal Revenue Code, property owners are allowed to swap properties without having to pay taxes.
Basically, a 1031 exchange allows real estate investors to pass on capital gains from their property to another with little or no tax obligations.
But there is a catch.
For an investor to be eligible for a 1031 exchange, they need to satisfy the following conditions:
- The swapped property must be used productively for business.
- Both properties need to be swapped for some kind of asset like a Real Estate Investment Trust (REIT).
- The resigned property must be equal to - or lower - in value than the replacement property.
4. Capital Gains
Capital gains are another great way to lighten your tax burden.
So, how does this work?
Well, capital gains can be defined as the profits made from the sale of real estate. Generally, there are two main types of capital gains namely:
- Short-term Capital Gains: These are profits from the sale of a property owned for less than a year. Taxes for such sales are not usually favorable to investors. Basically, these types of sales lack tax incentives.
- Long-term Capital Gains: These are profits from the sale of a property held for more than a year. Fortunately, these types of sales come with tax incentives. Generally, tax obligations on long-term capital gains are lighter than those on short-term gains. This means that you stand to benefit more through tax breaks when you sell your rental property after owning it for more than a year.
Obviously, there are other tax benefits available. This list only covers four of the best and most popular tax incentives for investment property owners.
In summary, it’s evident that knowing about your tax benefits can help lighten your tax burden. Despite the fact that taxes are here to stay, there are a few things you can do to minimize your tax obligations. In fact, coupling all these benefits can benefit you even more.