Here we are not going to tell you how to do taxes on your investment property in the traditional sense. Instead, we are going to tell you how to do taxes on your rental property in a way to legally reduce the amount of taxes that you pay on your real estate investments.
As an aspiring real estate investor, you should know that taxes are complicated in the real estate investing world. Thus, before undertaking any of the steps described below, you should make sure to consult with a CPA or another expert in order to verify which taxation methods apply to your real estate investment and which do not.
How to do Taxes: Tax Deductions
As a real estate investor who owns a rental property, one of the best tax benefits that you should keep in mind when thinking how to do taxes is tax deductions on rental properties. This means that if you own a rental property, you get some tax deductions on the expenses related to your rental property, including your mortgage interest. This is a great method to reduce a large portion of the taxes that you would otherwise have to pay.
For example, if you own a rental property, you get tax deductions for all costs of property management, repairs, maintenance, and mortgage interest. But not only that; if you live in a certain property and you use a part of the property as a real estate investment, like an in-house office, you get to deduct the costs of things like electricity, water, and heating used for this space as well as paper used for the printer or the gas used to drive to the office supplies store, as these costs are related to your real estate investment business, and therefore considered tax-deductible.
Related: Everything Real Estate Investors Should Know About Tax Season
So, next time you ask yourself how to do taxes on an investment property, make sure to keep in mind the great benefit of tax deductions in order to save yourself some money that you can use to grow your real estate investment business.
How to do Taxes: Capital Gains
Another thing you should keep in mind as a real estate investor learning how to do taxes on an investment property is capital gains. Capital gains are, in simple terms, the profits you earn from selling a real estate property. Whenever you sell a property, the IRS will be waiting for their share of the profit. This profit could be taxed in two different ways:
- Short-term capital gains
- Long-term capital gains
Short-term capital gains are profits made from selling a real estate property that you’ve owned for one year or less, while long-term capital gains are profits made from selling an investment property that you’ve owned for one year or more.
Currently, in the US, there are no specific benefits for short-term capital gains taxes. There are, however, benefits for long-term capital gains taxes, and that is a great thing for all real estate investors. Short-term capital gains taxes usually fall between 10% and 39% of your profit based on your income, and that is a very big hit on your profit from selling an investment property. Long-term capital gains taxes, on the other hand, can go between 0% and 20%, which is generally a better rate for a real estate investor.
If you’re a rental property investor, then you’re probably planning on holding your real estate investment for more than one year, which means that your capital gains taxes will probably be long-term, thus gaining you the benefit.
Related: All You Need to Know About Rental Income Tax
How to do Taxes: Depreciation/Recapture
While depreciation falls under deductions, it has much more to it than other types of deductibles and therefore deserves its own section.
Depreciation is a deduction on taxes taken on materials that break down over time. And while it is not a concept that is exclusive for real estate, it has its special use in real estate investments.
For example, if you own a rental property and you decide to install a new AC for $5,000, that AC might have a depreciation rate of 5 years, meaning that it is expected to become obsolete after 5 years. Since the AC is used for the purpose of your real estate investment, you get to write it off as a deductible. However, since the AC is not going to break down over a single year, you don’t get to write off its cost over one year. Instead, the $5,000 cost will be spread out over the duration of 5 years, meaning that you will get to write off $1,000/year for 5 years.
The best part about this is that your AC might not actually break down in 5 years, which means that you could get to deduct its cost from your taxes based on the assumption of depreciation even if the material does not actually depreciate or does not cease to exist at the end of its depreciation.
The same concept applies to your entire real estate asset, but not on the land that it’s located on. Since real estate assets (buildings, not lands) break down over time, most parts of your real estate property can be deducted through depreciation.
The IRS has determined that the deductible life of a residential real estate property is 27.5 years, while the deductible life of a commercial real estate property is 39 years. This means that as a rental property owner, you get to deduct the value of your property over the length of time.
Related: The Best States with No Property Tax for Real Estate Investing
The Down Side of Depreciation: Recapture
Recapture refers to the IRS’s ability to recapture your depreciation when you sell your real estate property. This means that the IRS can come after the taxes that you’ve been avoiding through depreciation after you’ve sold the real estate property; to be more precise, currently, the IRS can recapture 25% of the total deducted depreciation costs. You can, however, avoid paying recapture of appreciation through a surefire strategy; the 1031 exchange.
How to do Taxes: 1031 Exchange
When thinking about how to do taxes on an investment property, you should always consider the 1031 exchange. The 1031 exchange, also called like-king exchange, allows a real estate investor to purchase another investment property that falls under the same category as the original property (has to be real estate property) using the profit made from selling the first property in order to avoid paying the recapture on depreciation or the capital gains tax.
This allows real estate investors to snowball their real estate investments over the lifetime of their investing while avoiding these taxes (until their real estate investment journey comes to an end).
So, when you think about how to do taxes as a real estate investor, definitely check out the 1031 exchange, which you can use to your advantage.
You should keep in mind, however, that if you eventually cash out on your real estate investments, you will have to pay a large accumulated tax bill. Hopefully, at that point, you will have enough cash that it won’t even matter.
How to do Taxes: Conclusion
When it comes to doing taxes for your real estate investment property, having knowledge of these aspects and tricks can be used to your advantage as a real estate investor. So, how to do taxes? Stick to real estate, and enjoy the tax benefits that are exclusive for this field of investment. Just make sure to arm yourself with sufficient real estate legal and financial knowledge and have a CPA watch your back.
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