Disclaimer: Many agents at Brokers Guild are well-versed in real estate investment and tax exchanges, but we are not accountants or lawyers. Always speak to your CPA and/or seek professional legal advice with your real estate investments and tax matters.
A Closer Look at Tax Benefits of Real Estate Investment
Real estate allows owners the opportunity to build wealth in a few different ways: appreciation, by building equity (with mortgage payments), and through tax benefits.
Tax benefits are often overlooked since they’re less obvious than appreciation or equity, but they are a powerful tool for wealth building in real estate. It’s important to remember these points:
- Your investment property is a business, which makes any and all expenses deductible.
- Clean and clear records allow you to maximize your deductions and stay above board with the IRS.
- While profit is preferable, net losses from your investment can be worked to a tax advantage.
- When it’s time to start closing out your portfolio (when you retire, for example), there are strategies to defer some or all of the capital gains you make on appreciation.
The Importance of Record Keeping
When you file taxes, you submit a Schedule E, which is a profit and loss statement for your property. If you end up making money (if your gains from rental income are greater than your losses), you’ll owe taxes on the net income.
The IRS knows that Schedule E is rife with gray areas, so they pay close attention to the form. This is why you must run your business like a professional. Keep copious and clear records and statements of your accounts to get the tax benefits you’re allowed under the law and to avoid trouble.
Deductible Expenses for your Investment Property
Interest on your mortgage
HOA fees/condo fees
Mileage (to and from)
Loss & Depreciation
If you have net losses on your rental, you can deduct the loss (up to $25K) from your income.* Alternatively, if you own more than one property, you can net loss from one against another rental which may have been profitable.
*You can take the loss as deduction against your income when you earn an adjusted gross income of less than $100,000. Loss deduction phases out when you make over $150,000 — and in that case it can be carried over every year until you sell the property.
The IRS allows for a depreciation schedule on your property. They assume it’s going to take 27.5 years for the value of your improvement (the building, not the land) to go to zero.
Depreciation example You buy an investment property for $300K. Note — you must subtract the value of the land, since land doesn’t depreciate, before calculating your depreciation. A good rule of thumb is to use 20% of your purchase price, or else you can check the tax assessments and see what the assessor used. Let’s say the land is worth $60,000 of the $300K purchase price, so you now have $240,000 to depreciate.
Divide $240K by 27.5 years, which comes out to about $8500 per year. This means that $8500 may be counted as loss on your property’s profit and loss form (Schedule E) for the year, and can be deducted from your income (if you don’t make over the $150K limit). Awesome, right?
This is where it starts to get complicated, and it sometimes comes as a surprise to real estate investors. If you’ve depreciated value on your property and you don’t actually realize loss when you go to sell (you probably won’t since real estate tends to appreciate) the IRS counts your depreciation deductions over the years as income, and you have to pay income taxes on it when you sell.
Back to our $300K example from above, if you’ve owned a place for 10 years, you’ll have taken a total of $85K for depreciation over that time, so at time of sale you’ll have to pay about 25% back to the IRS, give or take (depending on your income bracket), which is about $21,000 in this case. Bummer, right?
Deductions Carry Over
Adjustable gross income limits of $100-150K were set in the 1980s and haven’t been adjusted for inflation. These days, it’s not uncommon to make over $150,000 year. What happens to your losses and depreciation when you make over the limit and can’t deduct them? The answer is, they can be carried over to the next year, and the next year, until you sell the property. And at that point, you’ll have a few options:
- Sell the property, and use your accumulated losses to reduce your income tax nicely for the year.
- Sell the property and purchase another investment property with a 1031 Exchange, which allows you to defer capital gains tax and carry over your losses to the next property (if they weren’t taken because your income didn’t allow for it).
Investor Specialist Can Help!
These tax calculations are complicated and there are a lot of moving parts, so, as stated up top, you’ll want a qualified CPA and a qualified real estate agency to help you work through your possible scenarios. We have tools which can help you determine every possible outcome, and a great network of service professionals in this arena to help you build your real estate investment team. Get in touch today for a call or a consultation!