We've talked in great detail about the financial freedom of earning passive income through real estate investment, but there are even more advantages to building wealth through real estate investing, and this info is just in time for tax season.
A huge advantage for investors who are smart enough to use real estate to their financial advantage, believe it or not, is tax benefits. Did you know that as an investor, you may intentionally structure your investments to minimize income tax and property gains?
But as with much of our tax laws, these added provisions can be quite confusing. That's why we're breaking down some of the biggest (and best-kept secret) tax benefits and rules to embrace and avoid when buying or selling property. Investing in property is one of many ways you can minimize your tax burden by investing in it, and we're going to look at ways you can continue to prosper as a real estate investor without having to give Uncle Sam all of your profits.
One of the biggest tax benefits of real estate investment income is the real estate investment tax deductions you’re able to make. We're not talking about superfluous tax deductions that will send red flags to the IRS, but reasonable deductible expenses that are safe and legal.
As someone who is investing in real estate, many of your annual tax deductions directly correlate to cost basis associated with operating, managing, and maintaining your rental properties, including: operation, management and maintenance of the property, such as:
The above list likely does not come as a surprise to many established or potential real estate investors, but you may be surprised to learn about other associated expenses that you are able to deduct from your taxes. Some other qualified business expenses include:
These fees may sound like small potatoes, but when added up and deducted from your income taxes, they can significantly drop your taxable income and leave you with more money in the bank. You know we love generational wealth. Deductions are a means of building it with real estate investment.
Passive income in property is money that is made from businesses in which investors have no physical participation. Passive earnings are usually earned by renting or investing in an investment property asset. You might be familiar with this tax benefit, which has actually gotten better.
In 2018, rental property investors could only compensate passive earnings with passive losses. However, passive income investors have gained some advantages since then. Businesses earning taxable income (QBI), including rental income, are eligible to receive a 20% tax credit. They may make this by taking out passes-through deductions.
Passing through deductions can deduct 20% of qualified business earnings (QBI) for tax purposes. Generally speaking, when a person owns rented properties through partnerships, LLCs or S Corporations, they are considered QBI under real estate tax laws. For example, a person who is in an investment bank and owns a property could earn up to $350,000 per year in rent. If you take the passing deduction, you may be able to write off as much as $6,000 of that amount under the law. Naturally certain rules and regulations need to be adhered to and you need to consult your tax professional, but the benefits are there and are undeniable.
Capital gains taxes can be assessed when you earn money from selling an asset, such as piece of property, and two types of capital gains associated with real estate investing are short-term capital gains and long-term capital gains.
If you sell a business property within one year of purchase, then you gain capital. While you don't have much of an alternative to selling, it can negatively affect your taxes. This means that gains can be used on income, according to the IRS.
For example, if you made $100,000 of income through your day job and also sold investment property for a $100,000, your taxable income doubles. When filing single, your additional earnings will have put you in your next tax bracket (as of 2016), which may result in more taxes than expected. Watch out for this when you consider offloading a property. It's short-term and big money, and the IRS will want their share!
On the flip side of the coin, you can gain long-term capital gains by selling an investment property asset you've held for an additional year, and more, which puts more of your money back in your wallet and available for other investment opportunities. This is primarily due to capital gains having an even lower taxation than ordinary income. If your income is low enough (to be determined by your trusted tax advisor), you can easily avoid paying taxes.
For example, say you and your spouse have made an average of $75,000 in one tax year and filed jointly. Long-term profits are taxed since you pay tax on zero income. It means you can keep any percentage gain you make by selling said property.
Sometimes governments develop tax codes specifically designed to attract investors to certain areas or industries. Real estate investment just so happens to have a few of those incentive programs. Let's examine the 1031 exchange and opportunity zone, which are two of the main tax benefits programs in the property investment sector.
1031 exchanges are in existence to promote reinvested real estate profits in new business deals. If the property bought for sale has the same value as it was when sold, it may also be traded for income tax. You will be able to avoid capital gains tax if you sell the property. The 1031 exchange period lasts for an indefinite period and is available in various forms depending on the timing of the transaction.
Learn more here, and always remember to work with a trusted tax advisor when taking advantage of these programs.
The opportunity zone establishes incentives for conducting business in certain underserved areas. A federal court has found that under the recent laws, investors may avoid capital gains tax by transferring profits to a qualified fund for properties in low-income or disadvantaged tracts of land, designated by the US Department of Treasury.
This is a great program for real estate investors that drives business and prosperity to up-and-coming areas. You can learn more about these benefits here.
People who are self-employed are usually bound to pay both the employer and employee portion of the FICA tax. That's not the case for savvy investors who own rental property, though, as the IRS doesn't classify the money you receive through it as earned income. What does that mean? You get to avoid the FICA tax, aka the payroll tax.
What does this look like practically speaking? Say you are self-employed through your own interior design business, and you generate $50,000 revenue with it. That money is considered earned income, and you're footing the bill for the payroll taxes for it at a rate of 15.3%! Yikes!
BUT, if it were rental property income you were collecting instead of that freelance revenue, that would be cash in your pocket.
There are tons of advantages to investing in real estate property, and even many options for investors who aren't ready to go the road alone. We know the tax talk can be overwhelming, but we wanted to give you an idea of the financial benefits beyond just collecting rent.
If you're interested in building generational wealth and collecting passive income through some of these options ,we'd love to discuss what's possible for your budget and dreams for the future. Reach out to us to unlock the potential of investment properties.
