It’s a sad fact of the tax code that the more money you make, the more you owe to the tax man. That’s especially true if you’re self-employed and paying the entire 15.3% Federal Insurance Contributions Act (FICA) tax for Social Security and Medicare yourself.
Investing in real estate, however, can bring in extra income along with a whole slew of deductions and tax preferences that offset your income tax and sharply reduce your total tax bill.
Deductions
First, many of the expenses associated with an investment property are deductible: mortgage interest, property taxes, insurance, management fees, condo fees, maintenance costs, and capital improvements. And if you set up a company to run your properties, you can also deduct typical business expenses, from advertising services and legal fees to equipment, meals, and mileage.
With careful tracking, everyday costs you’re paying anyway can become deductible. For instance, costs for the share of space in your home used for an office can be claimed. Mileage to run to the garden center and pick up some grass seed for the rental house is deductible—and if you grab some plants for your own yard and stop for groceries on the way home, those errands are accomplished on your deductible dime.
A newer tax break on rental income is the Qualified Business Income deduction. This allows deduction of up to 20% of income received through a pass-through entity, such as an LLC or S-Corporation. Rental income from an investment property meets the definition as well. There are complex rules about what kinds of businesses and income qualify, so contact us for help determining if you qualify.
Depreciation
On top of the tax deductions, you can take depreciation on properties owned for business purposes. The IRS sets the useful life of a residential property at 27.5 years and a commercial property at 39 years. That means if you buy a duplex rental for $350,000, you can deduct 3.6% of the purchase price, or $12,727 each year.
Better yet, the Tax Cuts and Jobs Act of 2017 now allows bonus depreciation for real estate. This means you can deduct the full cost of properties purchased before January 1, 2023 in the year of purchase. There are no income limits on this tax break. In addition, Section 179 allows the cost of major improvements to non-residential properties, like roofs and heating systems, to be deducted immediately rather than depreciated over many years.
Depreciation comes with a catch: when the property is sold, the depreciation must be paid back at a maximum rate of 25%, along with any capital gains taxes. But depreciation recapture only applies if you made a profit on the property. If your capital gains were less than the depreciation claimed while you owned the asset, you may only need to pay recapture taxes on the gain and keep the depreciation.
You can avoid the recapture of depreciation taxes by rolling the gains into another property. In what is known as a 1031 exchange, you can reinvest the profits and carry forward the tax basis of one property into another and defer taxes until that asset is sold. Repeat this process with increasingly valuable properties and you can build up a healthy stream of income with a tax burden minimized by all these deductions.
Tax-Advantaged Income
Another advantage of real estate investing: rental income is not considered self-employment income, so it is exempt from the 15.3% FICA tax. However, the IRS considers investors who buy and sell more than one property annually as self-employed dealers who are subject to this tax.
When it’s time to capture the return from real estate investment, capital gains from a sale will be taxed at a rate lower than regular income for most taxpayers—15% or 20% for those at high income levels. For those earning less than $78,750, the capital gains rate is zero.
These favorable long-term capital gain rates apply to property held for at least one day over one year. If you live in the property for two years, you’ll save even more: the first $250,000 of capital gains is tax free for singles; for married couples, up to $500,000 is tax free.
If you hold the property until death, your heirs will pay no capital gains taxes when they sell it. They may face estate taxes, but only if your estate exceeds $11.4 million (as of 2020).
Borrow Tax Free
Investment property also offers an asset you can borrow against, which provides a source of tax-free funds. You can refinance to take out equity, deduct the closing costs and mortgage, and use the money for whatever you’d like, including your next property investment.
Rental income covers the cost of your mortgage payments. Typically, the property will grow in value and rents will increase, while the mortgage payments remain fixed. Again, this is a strategy you can repeat to continually leverage the value accumulating in the property.
Add it all up, and these tax breaks and benefits can shrink the tax bill for investment income to nearly nothing. Supplementing your wage income with a side hustle in real estate can bring in extra income and potentially cut your total tax bill. Contact us today to discuss how this could potentially pay off for you.
- Toni L. Shears
Sources:
G. Brian Davis, “11 Ways to Significantly Lower Your Taxes as a Real Estate Investor,” Money Crasher, https://www.moneycrashers.com/lower-taxes-real-estate-investor/
Liz Brumer, “Top 5 Tax Advantages of Real Estate Investing, Millionacres, Dec. 17, 2019, https://www.fool.com/millionacres/taxes/real-estate-tax-deductions/top-5-tax-advantages-real-estate-investing/.
Brandon Turner, “The Ultimate Guide to Real Estate Taxes & Deductions,” https://www.biggerpockets.com/blog/real-estate-taxes-deductions
We are Arbor Wealth Management, a Phoenix-based firm that offers comprehensive financial planning services. We’re partners in your financial future. Like a conductor coordinating a beautiful symphony, we’re intimately involved in your financial future. We take the time to know how each instrument in your personal orchestra is performing, keeping all aspects of your plan in tune. We accomplish this by making sure your finances remain pliable, whether you are in an accumulation or distribution stage in life.
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