We talk about the tax advantages of real estate as if they are nothing … but they really are something.
At its founding, America was mostly undeveloped land. The tax code has evolved to heavily incentivize private investors to develop and maintain property for its highest, best use.
That’s who built America — private investors. They came not just for the yield and the cash flow, but also for the tax incentives.
Real estate investing is so advantageous from a tax perspective that even if you never realize a dime in positive cash flow, your investment can still be a net positive for the tax savings alone.
Here’s how real estate investors use their property to reduce their tax liability …
1. Deducting Expenses
First things first, employees can’t deduct most of their expenses … but real estate investors can. Yes, that includes the expenses incurred in running the property (insurance, marketing, maintenance, etc.) but it also includes any ordinary income that you can justify as a business expense. Talented real estate investors find a deductible “business use” for almost every dollar they spend. It really adds up.
2. Deducting Depreciation
I know it sounds awesome to be able to write it off your taxes every time you spend money … but what if you could write off expenses without spending money? Welcome to the wonderful world of depreciation, a benefit only available to real estate investors and not homeowners.
The IRS lets you write off a certain portion of your property’s cost basis as “wear-and-tear.” It’s an expense that doesn’t actually take money out of your pocket … but you still get to use it to reduce your tax liability every year for almost thirty years. To learn more about this magic tax trick, check out this article we published on the tax-saving power of depreciation.
3. The “Pass-Through” Deduction
Just when you thought we were done writing off non-expenses, most real estate investors get to write off a portion of their income. You heard that right — you get to treat certain income as a deductible expense for tax purposes.
It’s called the “pass-through” deduction. If you hold your asset in a “pass-through” entity like an LLC, you get to deduct up to 20% of the income from that entity as if it were an expense. That’s 20% of your annual cash flow that you get to write off as if it were money out of your pocket rather than in your pocket. Pretty cool, right?
4. Lower Tax Rates
As long as you hold your real estate investment for at least one year, the proceeds of the sale are taxed at the long-term capital gains rate, which is lower than the ordinary income or short-term capital gains rates. (And remember, the proceeds of a refi don’t get taxed at all!)
Cash flow gets taxed as ordinary income … but it is not subject to payroll taxes like W2 income.
5. The 1031 Exchange
You never even have to pay those long-term capital gains if you don’t want to. Section 1031 of the IRS allows you to purchase another property with the proceeds of the sale within a set time frame. Any dollar you flip into that new property via this technique, known as a “1031 exchange,” is not taxable.
You can do this indefinitely, flipping your proceeds into bigger and bigger properties (with more and more cash flow) without ever paying long-term capital gains taxes on the sale profits. Of course, if you ever want to pocket the cash it will be taxed, but it’s a cool trick to grow your net worth tax-free.
Need help understanding how these tax savings work? Reach out to us today. If you’re ready to flip your current rental property into a 1031 exchange, we always have an extensive inventory of turnkey rental properties ready for you to consider.