As a real estate investor, you need to have a good grasp of specific real estate tax strategies because it would help your investments yield better returns. These strategies, for the most part, are related to making tax work to your advantage. They range from avoiding capital gains tax, taking advantage of deductions, deferring tax with tax incentives, and leveraging tax-advantaged accounts. What this simply implies is that you ought to plan your taxes.
Tax planning is an integral part of any investment because it makes you invest smarter. That's why in the coming paragraphs, we'll discuss how to leverage the right tax strategies to get the most out of your real estate investments.
Understanding Taxation for Real Estate Investors
The taxation for real estate is quite peculiar. For instance, the income you get from rentals is taxed based on your tax bracket. For example, in 2023, if your rental income is $9,000, and your tax bracket falls under 12%, you will pay—$1,080 in taxes. That's (12% of $9,000). This is the same for capital gains tax.
Capital gains are gotten from the profit you make when you sell an investment such as real estate. The profit is taxed, and it will also depend on your tax bracket.
Another thing that affects your tax in real estate is depreciation.
Depreciation is simply a loss in value. This can be used to your advantage by deducting the depreciation of the real estate investment to account for or offset the costs of repairs of the wear and tear caused by depreciation. This also helps to reduce the tax liability of the real estate investment owners by lowering your taxable income.
Deductions and Tax Credits
In business, tax deductions bring down your income before taxes, and tax credits reduce the tax you should pay. As a real estate owner, you can reduce the tax you can pay by deducting certain expenses, especially those related to the maintenance of the property.
One good example is the mortgage interest deduction. The idea here is to reduce your income before tax based on the interest you paid on mortgages that year.
Also, if you own a property, use it for business, and the property has a useful life that can be determined, you can depreciate the property little by little throughout its life. This can be used to improve a house and maintain it.
You can also deduct property taxes for houses up to $10,000. And if you're even more involved in the house, you can deduct your entire property taxes as business expenses. Speaking of business expenses, your travel expenses relating to your home are deductible. However, this involves all travel expenses related to taking rent and not travel expenses related to repairs and improvements.
Other possible deductions include property management fees and insurance premiums.
1031 Exchange: A Powerful Tax-Deferral Tool
The 1031 exchange is a potent tool for real estate investors. Here one property is traded for another of higher value, and capital tax gains are then deferred in the process. The idea here is to create substantial wealth from their investments by reinvesting over and over again
Look at it this way, if you buy a property for $140,000, flip it, and sell it at a value of $250,000. The capital gain is $110,000, and you must pay tax. But if you immediately reinvest the money on a property of higher value, you will not pay that tax.
Benefits of 1031 exchange
- It helps you upscale your investments as you can use the sale of your property to get a better one.
- The investment style enables you to diversify your portfolio.
- It has tax savings benefits
Additionally, to be able to do a 1031 exchange, you need to-
- have at least a new property with a value equal to or greater in value than that being sold.
- have a replacement property in at most 45 days, and the purchase for the replacement property must be completed in 180 days.
You must note that if you get a cheaper property, you will pay tax on capital gains. Also, the 1031 exchange works only on invested properties, not personal properties.
Leveraging Tax-Advantaged Retirement Accounts
Regarding tax-advantaged retirement accounts, you can hold and invest in real estate from the money in those accounts.
Self-directed IRA encourages real estate investment with tax-advantaged earnings in the account. First, a self-directed IRA gives the owner complete control over the account, from investment in stocks to real estate.
However, when investing in real estate from your self-directed IRA, it should remain just an investment. You cannot actively run or live on the property. The property must also be purchased from someone not related to you, such as parents, grandparents, spouse or even the service provider of your IRA.
When investing in real estate through your IRA, there will not be any extra tax advantages such as depreciation or mortgage interest deduction. Instead, all profits will have to be put back into the IRA. However, one of the most significant benefits of the IRA is that it gives your money in that account a chance to work for you until you're ready to release it.
You can also use your self-established 401(k) to invest in real estate. Note that this doesn't include 401(k) sponsored by your employer for employees. When investing in real estate using a solo 401(k), certain conditions must be met. For instance, your solo 401(k) must allow real estate investment. Also, it would be best if you also were self-employed or at least had no other employees.
This real estate investment using solo 401(k) is beneficial because the returns can be put back into the 401(k), deferring the tax for a later date. This way, your assets grow with no taxes. The real estate types you can purchase with this include apartments, duplexes, raw lands, residential homes, mobile homes etc.
Investing in Opportunity Zones
An opportunity zone in real estate is a community described as "economically distressed" that gives tax breaks such as capital gain tax incentives to investors.
It was created by the 2017 Tax Cuts and Jobs Act as a way to drive growth and development in these distressed areas. The idea is to make these places more enticing to live, invest and work in. It's cheaper to buy homes here, and the tax breaks give you the option to make more.
For instance, if you invest in an opportunity zone, you can defer federal taxes for capital gains. You'll also get a 10% capital gain exclusion if you hold an investment in an opportunity zone for up to five years. This increases to 15% exclusion for up to 10 years and 100% exclusion after 15 years. But they're certain caveats, though. For example, you must develop the property by the value you bought the property to get the incentives.
To invest in these areas, you can go to the US Department of Housing and Urban Development (HUD) website and find the opportunity zones in the US. There are about 8,700 zones.
Maximizing Tax Efficiency through Entity Selection
Choosing the correct business entity is one of the biggest challenges real estate investors face. There's a lot to know about these entities, but for now, we'll focus on their taxing.
This is a pass-through entity with a straightforward business structure. It's headed by one person alone. Sole proprietors can't pay themselves salaries or wages; instead, they get their money through profits from the business. This means that all profits are subject to FICA tax and personal income tax for the business. The main feature here is that the lines between business and personal tax are blurred, all taxed as one. This can be an issue during litigation because a suit against you or the business affects the other.
S Corporations are usually for mid-sized and small private businesses. This is another pass-through entity because taxable income is taxed as the personal income of the owners. The good thing about this is that the owners pay personal income for the profits of the entity and then collect the profits as dividends that are tax-free.
These are normally large, publicly held companies. In C Corporation, the entity pays its own income tax, unlike S corporations and sole proprietorships. This means that the owners' corporation is taxed twice—one for profits from the company and one for their income from the profits. Thus, there's double taxation.
Limited Liability Company (LLC)
This is technically a legal entity and not a tax-paying one. If you own an LLC, you must choose whether you want to be taxed as a sole proprietorship, C corporation, S corporation, or partnership. The main idea of LLCs is to serve as a separate entity different from the owners. When taxed as a sole proprietorship, it protects owners from litigation affecting their personal properties, and when taxed as a C or S corporation, it's easier to manage and govern.
Loss Harvesting and Tax Planning
Tax-loss harvesting is a technique used by investors to reduce their overall taxable income by selling investments that have decreased in value, typically near the end of a calendar year around December. By realizing a loss on these investments, investors can offset up to $3,000 of their taxable income for that year. If the loss exceeds $3,000, it can be carried forward and applied to future tax years.
For example, if an investor realizes a capital gain of $1,000 by selling a stock that costs $15,000 for $16,000, they can intentionally sell another investment at a loss to offset the gain. If they sell a stock they purchased for $28,000 for $24,000, the difference of $4,000 can be used as a capital loss to offset the $1,000 capital gain.
It's important to note that capital loss is only realized when the investment is sold for a lower price than the cost.
Working with Tax Professionals
To get the best out of tax, you ought to work with a tax professional. So, what should a tax professional have?
- Tax professionals should have a degree in finance or accounting.
- They should have experience in preparing tax returns and knowledge of tax software.
- They should be able to advise businesses and individuals on tax-related matters, including payment, reporting, deductions, and credits, and provide support during audits.
You should note that they often work on a short-term or seasonal basis.
Finding the right tax professional
To find a qualified tax professional, you must understand your tax preparation needs:
- What do you want to achieve with your investment taxes?
- How do you want to do it?
Then check with your network for referrals. This way, you can get past several steps. When you finally get an interview, confirm their credentials, compare their fees with others and look for red flags such as a missing website, temporary office or refusal to sign a return.
Benefits of Real Estate Investing for Tax Deduction
Tax deductions in real estate investment can reduce taxable income. For instance, if you own a rental property, you can reduce your property taxes and qualify for mortgage interest deductions. These deductions are some ways of using real estate to avoid taxes.
There are also other tax advantages of real estate investing, such as capital gains, depreciation, 1031 exchanges, pass-through deductions and opportunity zones, to name a few. Real estate has more benefits than other investments because:
- Real estate is a relatively safe investment financially.
- Real estate doesn't require extensive knowledge.
- Real estate properties appreciate
- Real estate is not affected by inflation
- Real estate provides stable cash flow.
Still, that doesn't mean real estate investment is without risks.
Tax planning is essential for real estate investors because it enables them to invest smarter and unlock tax savings. Real estate taxation is unique, and understanding it can allow investors to take advantage of strategies such as avoiding capital gains tax, leveraging deductions and tax credits, and using tax-advantaged accounts.
Additionally, 1031 exchanges and investing in opportunity zones are powerful tax-deferral tools that can help upscale investments, diversify portfolios, and drive growth. So, before you dive into real estate investing, make sure you understand these real estate investor tax strategies