Tax Advantages of Investing in Real Estate

Apr 8

3 min read

The most common question I get when talking about real estate is about its tax advantages. It’s true that real estate can be complex, but understanding some of the most straightforward tax benefits can help you make more informed decisions when calculating and comparing your return on investment across different vehicles.

Operating Expenses:

As a real estate investor, you can deduct operational expenses tied to managing and maintaining your rental properties. These include mortgage interest, property taxes, insurance, utilities, repairs and maintenance, and any costs associated with managing that property– such as management fees, home office expenses, marketing and travel costs. Similar to running a small business, your taxes are calculated on your net income after deducting these expenses.

Depreciation:

After deducting your operating expenses comes one of the most straightforward tax benefits of owning rental property: depreciation. This tax deduction allows you to account for the wear and tear on your building over time, saving you thousands annually in tax liability. The value of your building depreciates each year over its useful life, as set by the IRS - 27.5 years for residential and rental properties and 39 years for commercial ones (land value excluded). Here’s an example of real estate depreciation in numbers:

$1,000,000 (Purchase Price incl. Closing Costs)

- $200,000 (Land Value is non-depreciable)

= $800,000 (Depreciable Basis)

÷ 27.5 (Residential Property Useful Life)

= $29,090 (Annual Depreciation)

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$120,000 (Collected Rents)

- $55,000 (Operational Expenses)

- $15,000 (Mortgage Interest)

= $50,000 (Net Income)

- $29,090 (Annual Depreciation)

= $20,910 (Taxable Income)

In this example, while you took home $50,000, your tax liability was only based on $20,910. It’s also common to see a net loss for tax purposes while still generating cash flow, you can use these losses to offset gains from other passive income–or, if you’re full-time real estate professional, to offset your active income as well. This net loss is especially true when you perform a cost segregation study, which leads me to number 3 of the list.

Cost Segregation:

A cost segregation analysis accelerates the depreciation of your property. Instead of depreciating your residential property value over 27.5 years, this analysis itemizes your building components and depreciates them over shorter lifespans per IRS guidelines– for example a new boiler will have a much shorter lifespan than a new roof. While these studies are expensive, the tax savings outweigh the cost of the study.

This strategy isn’t for everyone, consult a tax professional to determine if it suits your situation. There are factors to consider, such as how long you plan to hold the asset, your overall tax situation, and the depreciation recapture you will be liable for when selling the property.

1031 Exchange:

When it comes time to sell your asset, instead of getting taxed on your capital gain, you can roll over your sale proceeds into another like-kind investment property and defer any capital gain tax liabilities. This is a great advantage that helps grow your portfolio fast. The most common type of 1031 exchange must follow a specific timeframe and legal framework. You must identify up to three replacement properties within 45 days from closing on your property, and you must close on one of them within 180 days - 45 days to pick, 180 days to buy. You will also need to hire a qualified intermediary, often recommended by your closing attorney or accountant, as a third party that will ensure your proceeds are held in escrow and that you remain compliant during the process. Some experienced investors use a reverse 1031 exchange, this is when you buy your replacement property before selling your current one.

No matter what industry you are in or what you do for a living, adding income-generating real estate to your portfolio is a must. The tax advantages alone make it worth exploring. If you're busy with your day-to-day, partnering with a trusted property manager or joining a fund like ours is a great way to participate, feel free to reach out to learn more.