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The Tax Benefits of Real Estate Investments

If you are an adult between the ages of 20 and 50, then you most likely have considered, in a way or another, to invest in real estate. “Real estate is the right road to financial success,” people say, while others may be more sceptical about making money in real estate.

If you are sceptical, we recommend that you read all the successful stories of how real estate created millionaires, let alone a few billionaires. There is money in investing in real estate business. At some point, everyone should invest in a form of real estate. Real estate investments vary from land to various types of buildings, which creates endless opportunities for investors. Moreover, real estate investors are constantly finding creative ways to capitalize any opportunity they can find. Making a profit is what gets real estate investors out of bed; to make that profit that is known as taxable income. Don’t be scared, nothing illegal here! Any real estate investor must be creative in doing taxes to make use of investment property tax deductions. This leads us to the tax benefits of real estate investments which real estate investors make use of.

So, what are those alleged tax benefits that real estate investors speak of?

Drum roll, please!

Rental Income

Real estate investors must be aware that rental income is not subject to social security and FICA (Federal Insurance Contributions Act Tax). FICA tax varies at two levels: if you’re self-employed, you will have to pay FICA of 15.3% of your income, and if you have a salaried income, the percentage is lower than half at 7.65%. This may seem like not much, but numbers can add up. Let’s take a salary of a self-employed person and calculate the FICA tax he/she is out to pay. Assuming the salary is $90,000, you will have to pay FICA $13,770. However, earning the same sum of cash through real estate investments in rental income is not subjected to social security nor to FICA tax.

Related: All You Need to Know About Rental Income Tax

Appreciation

Appreciation helps real estate investors who are interested in the buy-and-hold type of real estate investments. Appreciation is the increase of an investment property’s value over time. If you’re considering buy-and-holds as a real estate career choice, then you must be aware that no taxes apply on the appreciation of your investment property when not selling. The IRS cannot tax appreciation on your properties.

Related: The Best Tips for Forced Appreciation in real estate investing.

Depreciation

The depreciation of an asset is the wear-and-tear that happens to the property over time. It applies to all real estate investments with no exception. For commercial properties, real estate investors can deduct the value of the property over the course of 39 years. On the other hand, when it comes to residential real estate, homeowners and real estate investors can deduct the depreciating value of a property over the course of 27.5 years.

Knowing how to make money in real estate through smart real estate investments can be as simple as understanding how depreciation on an investment property can be considered a tax benefit. Let’s take a property that’s worth $150,000. You will need to take the price of the land the property sits on out of your depreciation calculations, which is 15% of the entire value of the property then divide it by 27.5 years assuming it’s a residential real estate. You must calculate the land value which, in this case, is $22,500. You will be left with the total depreciation of your property, which is $127,500. You can divide it by 27.5 years to come up with the deductible tax, which is $4,636. You can deduct the depreciating value of $4,636 yearly for 27.5 years.

Note that properties don’t necessarily depreciate at that rate. If you perform maintenance on your property regularly, your property will most likely appreciate, while you are getting tax breaks from depreciation.

1031 Exchange

Under Section 1031 of the Internal Revenue Code, a taxpayer can defer recognition of capital gains and income tax on the exchange of different types of real estate investments. This means that if you know how to invest money in real estate, you can delay paying taxes on capital gains that result from selling an investment property if you invest your gains in another property. Basically, you would exchange your current property for another.

In order to qualify for 1031 Exchange, real estate investors must complete the purchase of the new property within 180 days of the sale of the old property and it has to be of the same kind, meaning you can’t sell real estate investments that are lesser in value than the original investment when using 1031 exchange. Another major qualification that’s required is the use of an intermediary to complete the transactions, which includes transferring the ownership of the old property to the buyer and the ownership of the new property to you. Using a qualified intermediary can ensure the process goes smoothly as it can be a complex process that must be handled with experience.

Capital Gains

Capital gains refer to the profit that real estate investors make from the sale of investments, and in this case, real estate investments. Of course, there’s a capital gains tax. The capital gains tax rate varies from one person to another, and its main determinant is your income tax bracket.  A false misconception about capital gains is that they only apply to the richer slice of society. In fact, capital gains apply to any investor who sells an investment whether in real estate or the stock market, so the same rules apply.

Another major determinant of capital gains tax is the investment period. From an ownership period perspective, capital gains can fall into two categories:

  • Long-term capital gains are gains from an investment after the holding period of a year or more.
  • Short-term capital gains are gains from an investment that you’ve had for less than a year.

Capital gains taxes differ when comparing one real estate investor to another. Note that long-term capital gains tax rates are significantly lower than short-term capital gains tax rates. This means that a real estate investor specialized in buy-and-holds will pay lesser capital gains tax than a house flipper.  It all comes down to the type of real estate investments you make and the investment strategies the real estate investor chooses to proceed with.

Related: The Right Way to Do Taxes as a Real Estate Investor

If you play it smart and stay informed about the different variables that affect capital gains tax, you can make use of investment property tax deductions to keep your capital gains tax rate very low. Many have succeeded at it.

We’ve only just begun to scratch the surface of investment property tax deductions and how to use them. Real estate investors with rental properties can make use of rental property tax deductions and factor in rental expenses to shield their rental income and income properties from high taxes.

Is real estate a good investment?

The real estate world was not build for the faint of heart. Real estate investors must be creative in finding solutions to any cuts in their profits. In the real estate business, many taxpayers utilize tax deductions to their advantage to stay ahead of the game, and so should you!

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Ahmad Shukri

Ahmad is Content Writer at Mashvisor with a degree in marketing. He enjoys writing about everything related to real estate and especially the top markets for investment properties.

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