In this blog, we are going to list few benefits of real estate taxes and ways to help you do taxes on your rental property in a way that legally reduces the amount of taxes you have to pay on your real estate investments.
However, make sure to consult with a qualified accountant, a CPA, or another expert before undertaking any of these steps to help you confirm which taxation methods apply to your real estate investment and which do not.
Real Estate Taxes: Tax Deductions
The first benefit of owning a rental property is that you are able to deduct almost all expenses you have to pay to manage your property. You get deductions on everything related to your rental property such as the mortgage interest you pay on the loan, property management, maintenance, and even the paper you buy for your printer.
Additionally, such tax deductions can come in handy if you live in a certain property and part of that property is used as a real estate investment. For example, if you have an in-house office, you can deduct a portion of your home expenses which are related to your real estate investing business. For instance, internet bill, electricity bill, home repairs, the gas used to drive to the office supplies store, etc. are all deductible from real estate taxes. The benefit is that it’s not like you don’t already have to pay those bills anyway, but now you could reduce a large portion of some of them.
Real Estate Taxes: Depreciation/Recapture
This section covers one of the tax deductions you’ll be able to claim on your real estate taxes – depreciation. Depreciation is a tax deduction taken on materials that break down over time. Let’s explain this further with an example.
Suppose you decided to buy a new printer for your rental property investment that costs $5,000. That printer might have a depreciation rate of 5 years, meaning that it is expected to become obsolete after 5 years. Because the purpose of the printer is for your real estate investment, you get to write it off as a deductible. However, since the printer is not going to break down over a single year, you can’t deduct its cost over one year. Instead, the deduction will have to be spread out over the duration of 5 years, meaning you could deduct a portion of the $5,000 the first year, another portion the second year, and so on until you depreciate the entire printer. In simpler words, you will be able to deduct the total cost, but you have to do so over time.
Depreciation and Residential Real Estate
This is also beneficial for and applies to residential real estate as it is an asset that breaks down over time. The Internal Revenue Service (IRS) allows real estate investors to deduct the cost of the building (not the land it sits on – lands don’t break down over time) just like you might deduct a printer. The IRS determined the deductible life of a residential real estate property to be 27.5 years, and 39 years for a commercial real estate property. This means that you, as a real estate property owner, get to deduct the value of your property over that length of time.
The best part about depreciation is that your printer or residential property might not actually break down, which means that even if the asset does not actually depreciate, you still can deduct its cost from your real estate taxes based on the assumption of depreciation.
The Dark Side of Depreciation: Recapture
Recapture is the IRS’s ability to recapture your depreciation when you sell your real estate property. This means that when you sell the real estate investment, all the real estate taxes that you deducted through depreciation may be paid back to the IRS. In fact, the IRS can require real estate investors to pay 25% of the total deducted depreciation costs.
However, there is a strategy that helps you avoid paying recapture of depreciation tax, and that is the 1031 Exchange which we will explain more in details in the next section.
Real Estate Taxes: 1031 Exchanges
When thinking about real estate taxes, you should keep this strategy in mind. As mentioned before, the 1031 Exchange is a legal strategy used by many successful real estate investors to avoid paying recapture on depreciation taxes when they sell their property. It is named after the IRS tax code that brought the exchange into existence (Section 1031).
Basically, this strategy benefits real estate investors because it allows them to sell an investment property, use the proceeds to buy new property investment (or properties of equal value), and then defer paying real estate taxes until that next property is sold (unless they use another 1031 Exchange again).
This exchange is a very simple and beneficial strategy for investors; however, there are procedures that must be followed strictly, otherwise the real estate investor might be forced to pay the tax and lose the entire benefit.
- The Exchange Must Be For a “Like-Kind Asset.”: For example, you can sell a house and buy an apartment, but you can’t sell a house and buy a restaurant.
- There Are Time Limits: After selling the investment property, the IRS requires real estate investors to identify the property they plan to buy within 45 days, and within 180 days, they must close on that property.
- You Can’t Touch the Cash: After selling the property, you can’t touch the profit, and instead, you must use an intermediary to hold on to the cash until you close on the new property.
Real Estate Taxes: Capital Gains
A very simplistic definition of capital gains is: They are the profits you make from selling a property. The IRS will want their share of the profit that a real estate investor makes when he/she sells a property. This profit can be taxed in one of two ways:
1. Short-Term Capital Gains:
These are the gains made from selling an investment owned for one year or less. In the US, there is currently no special tax treatment or benefits for short-term capital gains. Real estate investors are simply responsible for paying real estate taxes at whatever their IRS-defined tax bracket is, based on their income.
2. Long-Term Capital Gains:
These gains are the ones made from selling an investment owned for over one year, and they are much more favorable than the short-term tax. Short-term capital gains taxes commonly fall between 10% and 39% of the profit based on the investor’s income, which is a very big hit on the profit from selling an investment property. On the other hand, long-term capital gains taxes range between 0% and 20%, which is obviously a better rate for a real estate investor.
If you’re a rental property investor, then you’re possibly planning on owning your real estate investment for more than one year, which means that your real estate taxes will be long-term long, hence gaining you the benefit.
Real Estate Taxes: Tax Deductions for Vacation Rentals
As for taxes on vacation rentals, you can deduct various expenses including insurance, mortgage interest, housekeeping, repairs, and even towels and sheets. In addition, you can write off depreciation. What is deductible depends on a number of factors, especially how often you use the vacation home and whether or not you rent it out.
The tax law also allows you to rent out your vacation home for up to 14 days a year without paying taxes on the rental income. However, to reduce taxes on vacation rentals, owners need to own at least 10% of the property and be actively involved in the rental property – that means performing duties like approving new tenants and coming up with rental terms.
Real Estate Taxes: No Self-Employment/FICA Tax
The last benefit of real estate taxes we’re discussing is that the income you receive from your property investment is not taxed as “earned income”; therefore, it is not subject to Self-Employment Tax, which is a major tax most Americans pay.
FICA (Federal Insurance Contributions Act) tax is a 15.3% tax split 50/50 between an employer and the employee. If you are self-employed and don’t have an employer, then you are responsible for the full 15.3% – this is known as Self-Employment Tax. Luckily for real estate investors, this tax is not due because the US Government does not look at the rental real estate as a job or self-employed business.
However, you need to keep in mind that this depends on how you legally structure your real estate investments. For example, holding properties in a c-corporation and paying yourself a salary or a management fee could trigger the FICA tax.
Before concluding, it should be mentioned that how many real estate taxes reductions you’re allowed to get depends on what kind of real estate investor you are: either a real estate professional or a passive investor. The IRS defines real estate professionals as those who spend more than half of their working time in the rental business. If you are a professional, your rental losses are fully deductible against all income. If you are a passive investor – someone who spends less time dealing with rental properties – then your losses will be passive and will only be deductible up to $25,000 against your rental income.
When deciding to enter the real estate investing business, it’s to your advantage to have some knowledge of the benefits of real estate taxes and how to legally reduce the amount of tax you have to pay on your investment. Still, it is absolutely crucial to make sure that you consult a CPA to help you choose the best tax deduction strategy for you.
For more tips on becoming a successful real estate investor, check Mashvisor and use Mashvisor’s investment property calculator to help you calculate your expected expenses and returns.