Buying traditional or Airbnb investment property is one of the best ways of growing your wealth. Owning real estate allows you to create a passive income, build equity, hedge against inflation, leverage funds, build generational wealth, and be your own boss. And there’s another major advantage: real estate tax benefits.
If you own real estate and you’re not aware of all the tax advantages available to you, then you’re missing out on different ways to save money.
7 Real Estate Tax Benefits
Here are some of the common investment property tax benefits that you should be taking advantage of:
This is one of the major tax benefits of real estate investing. Just like any other kind of property like vehicles, machinery, furniture, and equipment, buildings break down in value over time. The Internal Revenue Service (IRS) allows a depreciation deduction for the wear and tear of the property. The amount deducted each year will be determined by:
- The value of the property
- The depreciation method used
- The recovery period for the rental
The IRS allows property owners to deduct depreciation on residential rental property for 27.5 years. Modified Accelerated Cost Recovery System (MACRS) is the approved depreciation method.
2. 1031 Exchanges
The 1031 exchange is named after section 1031 under the IRS tax code. It refers to a legal transaction where a real estate investor exchanges income property for like-kind property. This way, you can defer paying taxes on capital gains until the next property is sold.
To complete a 1031 exchange, your investment properties must satisfy the following criteria:
- The value of the replacement investment property must be greater than or equal to that of the resigned property
- The exchanged properties must be used for any productive purpose in business
- Properties involved in the exchange must have the same character or nature, even if they differ in quality or grade For example, a single family home would generally be like-kind to another single family home
- You must close on the investment property you want to acquire within 180 days
Related: Learn All About the 1031 Exchange Rules for Investment Property
However, section 1031 doesn’t apply to exchanges of partnership interests, stocks, bonds, REITs, certificates of trust, or securities.
3. Lower Capital Gains Tax
Capital gains refer to the profits that real estate investors make when they sell a rental property. These gains are generally taxed in two ways:
- Short-term – This applies to capital gains on income properties that were held for 12 months or less. Investors are required to pay taxes at their usual IRS-defined tax bracket.
- Long-term – These are capital gains made on homes that were held for more than one year. Taxes on long-term gains are more favorable than taxes on short-term gains.
Overall, real estate taxes on capital gains are much lower compared to income tax charged on ordinary income.
Deductions are basically tax write-offs that apply to anyone owning rental property. This may include property insurance, property tax, mortgage interest, property management fees, advertising expenses, property repairs, and ongoing maintenance. Some real estate investors choose to buy rental property under a limited partnership (LP) or limited liability company (LLC). Such investors are entitled to additional rental property tax deductions such as:
- Professional and legal fees such as bookkeeper, attorney, or accountant
- Office space (including home office)
- Office equipment such as a desk, printer, phone, or laptop
- Travel expenses including parking fees and vehicle mileage
- Internet costs
- Business meals with partners or prospective clients
- Cost of seminars or conferences related to real estate
- Membership fee for trade associations
Take note that many of these deductions are only for a portion of the expense. For example, you might only be allowed to deduct 50% of your home office expenses.
Be sure to keep good records of all your expenses so you can enjoy the real estate tax benefits from the annual deductions.
Related: The Real Estate Investor’s Guide to Airbnb Tax Deductions
5. Tax-Deferred Retirement Accounts
There are special accounts like individual retirement accounts (IRA) and health savings account (HAS) that allow you to invest in assets like real estate tax-deferred or tax-free. The accounts might have restrictions on the kind of investment that can be made, as well as annual contribution limits. Do your due diligence in advance before making an investment.
6. Opportunity Zones
According to the IRS, a qualified opportunity zone (QOZ) refers to an economically-distressed community where new investments might be eligible for preferential tax treatment. QOZs were created on December 22, 2017, by the Tax Cuts and Jobs Act. Their purpose is to spur job creation and economic development in distressed communities. After selling an investment property, real estate investors can put the capital gains into an opportunity zone fund. This allows them to defer or avoid paying capital gains tax on their original investment. Some of the original real estate tax benefits have passed as the program came with certain deadlines. However, there are still other tax benefits to be gained from investing in opportunity zones.
Related: 21 Best Opportunity Zones to Invest in Real Estate in the US
7. Cost Segregation
Cost segregation is a strategy that allows real estate investors to take advantage of accelerated depreciation to boost cash flow, and thus minimize the taxes paid on rental income. This tax strategy could apply to:
- Purchased properties
- New constructions
- Leasehold improvements
- Remodeling or expansion
Be sure to consult a tax professional to find out if cost segregation is right for you. Also, realize that there is a cost involved in getting a cost segregation study done.
Whether you are an investor in traditional or short term rental properties, there are many real estate tax benefits you could enjoy. However, many people are unaware of the tax incentives that are available to them. It requires effort and careful planning to maximize your tax deductions while staying compliant with the regulations involved. This is why it is advisable to hire a tax expert or an experienced CPA. What you pay them is nothing compared to the savings you can make. Maximizing your tax breaks will boost your return on investment and keep you on the path to financial freedom.
Related: Your Guide to Short-Term Rental Property Tax Deductions