Top 7 Tax Benefits of Real Estate Investing

real estate tax benefits
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If you’re financially capable of investing in real estate, it’s a great way to make money. You can average a return on investment (ROI) of 8.1 percent on real estate as of 2022.

Also, real estate investors are entitled to several tax benefits.  Here are 7 tax benefits of real estate investments:

  1. Qualified rental expenses can reduce taxable rental income.
  2. You can reduce taxable income through depreciation.
  3. You can pay lower tax if you choose long-term capital gains.
  4. You can offset your FICA tax with rental income.
  5. You can defer tax payment if you qualify for a 1031 exchange.
  6. You can claim a pass-through deduction before 2025.
  7. Investing through IRAs are tax-deductible. 

Below is a brief explanation of each tax benefit, as well as explanations about how you can use each to reduce your taxable real estate income.

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1. Qualified Rental Expenses Can Reduce Taxable Rental Income

Most expenses from occupying, managing, or maintaining a property can reduce your taxable rental income. According to the Internal Revenue Service (IRS), the following rental expenses are deductible:

  • Mortgage Interest
  • Property Tax
  • Repairs
  • Advertising
  • Maintenance
  • Utilities
  • Insurance

However, you cannot deduct improvement costs. If you restore an old property or renovate part of a property for a new or different purpose, you cannot deduct those expenses from your taxable income.

On the other hand, if you fix a banged-up faucet, replace broken windows, or do anything else to ensure that the property stays livable, you can count those as deductibles. 

2. You Can Reduce Taxable Income Through Depreciation

Over time, your real estate investment will experience wear and tear. Since you calculate property tax based on its market value (among other factors), it doesn’t make sense to tax a 20-year-old house the same way you’d tax a home purchased yesterday.

For that reason, it’s acceptable to deduct depreciation from your taxable real estate income. Depreciation provides a rough estimate of the value a property has lost over time.  

There are various ways to calculate depreciation. The most widely used method is the straight-line method, dividing a property’s cost basis by its useful life based on the property type.

For example, if you purchased a residential property for $500,000, its useful life per the IRS rules is 27.5 years. Therefore, the annual depreciation equals about $18,181.82.

Calculating depreciation isn’t always as straightforward as the example shown above. You also need to account for the type of property, whether the property has additional fixtures, whether you’ve incurred other expenses when you purchased the property, etc. 

3. You Can Pay Lower Tax if You Choose Long-Term Capital Gains

Real estate is a capital asset, which means you purchase it with the expectation that:

  • The asset will stay in your possession for a year or more. 
  • The asset will give you a substantial return on your investment whether you keep or sell it.

If you sell the property within one year or less after the date of purchase, you pay a short-term capital gains tax equal to your ordinary income tax rate per your tax bracket. 

If you sell the property a year after the date of purchase, you only need to pay a long-term capital gains tax, usually around 15 to 20 percent of your long-term capital gains, depending on your tax bracket.

Sometimes, you don’t even have to pay any capital gains tax at all.  In other words, long-term capital gains tax is lower than short-term capital gains tax.

You may want to hold onto your property a little longer before you sell it.

4. You Can Offset Your FICA Tax With Rental Income

Whether you’re self-employed or working for someone else, you must pay a tax mandated by the Federal Insurance Contribution Act (FICA). The FICA tax funds Social Security and Medicare benefits. 

You only shoulder part of the FICA tax if you’re an employee. But, if you’re self-employed, you have to shoulder the full 15.3% tax on top of other self-employment taxes.

Luckily, FICA tax doesn’t include rental income in its calculations unless your business entirely depends on that income to stay afloat. 

5. You Can Defer Tax Payment if You Qualify for a 1031 Exchange

If you want to defer paying your real estate taxes to a later date, one option you can take is the 1031 exchange. This exchange involves your real estate property for a similar property to cut your tax liabilities.

To qualify for a 1031 exchange, the asset you’ll exchange for your real estate must meet all three criteria below:

  • The property must be tangible real or personal property.
  • The property must have a value equal to or greater than your real estate’s value.
  • You must use the property for commercial purposes. 

For a better idea of how 1031 exchanges work, watch the YouTube video below:

6. You Can Claim a Pass-Through Deduction Before 2025

Most businesses (including property management firms) can claim a pass-through deduction. The deduction equals 20% of your net rental income, and you can deduct it directly from your income taxes.  

To get a pass-through deduction, you must satisfy all of the following criteria:

  • You must have your rental property or own that property through a qualifying pass-through entity.
  • You must have a net rental income, not a net rental loss.
  • Your total income must exceed your total deductions before applying the pass-through deduction.

As of this writing, the legal provisions that include the pass-through deduction will expire after 2025. However, some lawmakers plan to extend the aforementioned requirements due to their substantial revenue-generating potential. 

7. Investing Through IRAs Are Tax-Deductible

Generally, contributions for traditional individual retirement accounts (IRAs) are tax-deductible. You can use your IRA to purchase real estate property and defer taxes, provided you meet the criteria below:

  • You must keep the property solely for investment purposes. You cannot live on the property on a temporary or permanent basis.
  • You cannot work on the property directly. If you want to perform repair and maintenance work, you must do it through a third party.
  • You are responsible for all expenses on the property. You can pay for the costs and losses through your IRA, but you have to keep your IRA funded at all times. You also cannot use depreciation as a deductible.
  • All property income must go to your IRA. 
  • You cannot mortgage the property. 

If you want to buy real estate with your IRA, I strongly recommend getting professional help. Otherwise, you may put yourself in a financial bind or risk fighting off potential lawsuits.

Is Investing in Real Estate Worth It?

Now that you now the 7 tax benefits of investing in real estate, it is time for you to decide whether or not real estate is a good investment for you.

I personally think real estate is an excellent investment option because it can create passive income, build your net worth, and create leverage when you need access to capital or a loan.

Whatever you decide, make sure that you do your due diligence before you invest in real estate.

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