If you’re a real estate investor, saving money on your taxes can be just as crucial to your bottom line as the deals you make daily. While numerous tax strategies that you can implement to save on taxes exist, a few of them are more valuable than others. Here, we discuss four of the top tips for saving money on real estate taxes.
1. The 1031 Exchange
A 1031 exchange is a way for real estate investors to defer capital gains taxes when selling an investment property by reinvesting their profits in a replacement property. This is also called a like-kind exchange. It is essentially a swap of one investment property for another. “Like-kind” refers to the fact that the properties in the exchange must be similar, and the exchange property must be of equal or greater value than the property sold. Because it is rare for an even property swap to occur between parties, the most common type of exchange is the delayed “forward” exchange. In this case, the sold property funds are sent to a qualified intermediary. The intermediary holds the transaction funds from the sale of the first property until they are transferred to the seller of a replacement property.
2. The Business Tax Deduction
The expenses that you incur from owning a property are deductions that can be advantageous for part- and full-time real estate investors. Qualifying expenses include mortgage interest, insurance, fuel used for travel to and from the property, phone, internet, home office, etc. If some expenses are shared for business and personal use (such as your phone or internet), be sure to divide the expenses accordingly and only deduct what is used for your business.
Also, note that the allowable expense deductions must be ordinary (common in your field) and necessary (aid you in conducting business).
3. Long-Term Capital Gains
When selling a property for profit, a capital gains tax can be assessed. If you sell a property in the short term (within one year of purchasing it), the profit you make from the sale is considered income. This can put you into a higher tax bracket and increase taxes that you owe significantly (the short-term capital gains tax can be as high as 35 percent!). However, you can avoid a large tax bill due to selling an investment property if you can hold onto the property until after the first anniversary of purchasing it. That’s because the long-term capital gains tax rate is lower than the rate on income tax that applies for short-term gains (the long-term capital gains tax usually tops out at 15 percent, depending on tax filing status and income).
4. Depreciation Losses
Depreciation, the gradual loss of an asset’s value, allows you to take a tax break for property wear and tear over time. By deducting depreciation of real estate investments on your taxes as an expense, you lower your taxable income. This could potentially lower your tax liability.
According to the IRS, the expected life of a parcel is 27.5 years for residential properties and 39 years for commercial properties. The depreciation deduction for the entire expected life of a parcel can be taken. For example, if you buy a house valued at $300,000 (value of the structure, not the land it sits on) as an investment property to rent, you divide that value by 27.5 years, which gives you $10,909. That is the amount you can deduct in depreciation each year on your taxes.
Be aware that if you ever sell the property, you will have to pay the standard income tax rate on the depreciation you claimed (Note: this is “depreciation recapture” and can be avoided with strategies like a 1031 exchange discussed in point 1.) You can also possibly depreciate improvements you make to investment properties like replacing the roof or similar significant upgrades.
Speak to your accountant about these money-saving strategies, as well as other potential ways to keep more profit in your pocket when conducting your real estate investment business.