Last Updated on January 23, 2024 by Mark Ferguson
Real estate can be a great investment thanks to cash flow, buying below market value, leverage, and appreciation. However, one of the best reasons to invest in real estate are the tax advantages. There are tax advantages to buying rental properties or a personal house. House flipping is usually treated as a job and does not have as good of tax advantages, but with the new tax laws helping corporations, even house flippers get tax breaks.
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Why does the government give preferential tax treatment to real estate?
Real estate has some of the best tax advantages of any investment or asset. The government wants people to buy houses because it is one of the best ways to help the economy. The more houses they can get people to buy, the better the economy usually does.
It is very common for a rental property to produce a profit, but thanks to depreciation, and still show a loss on your taxes. You can also deduct the interest portion of a loan on a rental property or perform a 1031 exchange, which allows you to sell a property without paying capital gains taxes. There are tax advantages to buying a house to live in as well. When you buy a personal house and live there for at least 2 years, you may be able to take any profit tax-free without any restrictions. Expenses like the interest portion of your payment can be deducted in some cases as well. The tax savings on real estate has been affected by recent tax laws, but most of the advantages have increased! There used to be very few tax breaks when flipping houses compared to most jobs, but if you flip in a corporation, you can expect lower taxes as well.
Please consult an accountant for specific tax questions
This article is meant to offer a broad overview of the tax advantages of rental properties, not specific advice. I am not an accountant or an attorney, and if you are looking for tax advice, please talk to a tax professional. There are also several tax calculators and estimators online that can assist you. This article gets much of its information from the IRS tax code on rental properties.
Is the interest on a mortgage deductible?
The interest you pay on a rental property can be a deduction on your tax return. Your entire payment cannot be deducted because part of your payment is equity pay down, which is not deductible. Paying down equity is not considered a business expense since the money is not spent on repairs or maintenance but rather used to reduce debt.
The interest on a house you live in can be deducted as well, but for most people, this is no longer applicable. The new tax code increased the standard deduction, which means most people use the standard deduction and do not itemize deductions. You only deduct the interest portion of your payment if you are itemizing deductions. There is also a cap of $10,000 per year that can be deducted from your house for interest and state income taxes. If you live in a state with very high taxes, you may not be able to deduct as much as you could before.
Like with any other business, just about all expenses are deductible when you flip houses. If you are financing flips, the interest can be deducted in most cases.
Tax advantages on a personal house
Many people have no idea that the profit on a personal house or a house that you live in is tax-free in most cases. This is not a 1031 exchange.
If you live in a home for at least 2 out of the last 5 years, you most likely will not pay taxes on the profit (up to $250,000 for an individual or $500,000 for a couple). You can live in the house for 2 or 30 years and still have a tax-free profit. You do not have to buy a new property or invest that money either. You can blow it on Slurpees and lottery tickets if you want. There are some restrictions if you use the property as a rental or business.
Because you can avoid paying taxes on the profit of a home when you live in it as your personal residence, buying a home below market value can be a huge advantage. You may have to buy a home that needs work, but you can repair the home before moving in or repair it slowly over the next two years. Once you have lived in the home for two years, sell the home and hopefully make a large profit. You will pay no income taxes on that money you make as long as you do not make over $250,000 or $500,000, rent the home out, or use the home for business. Once the home is sold, you can repeat this process over and over.
You can use the profit from the home you sold as a down payment for your next house, which may allow you to keep buying more expensive homes. You could also buy the next home with as little down as possible and use the cash you made to invest in rental properties or something else. The best part of this strategy is the taxes are not deferred as they would be with most retirement plans or a 1031 exchange: they are forgiven forever.
Taxes on house flips
House flipping is considered a business or job and not an investment. If you are flipping houses, you will usually pay the ordinary income tax as if you were working at a regular job. However, some things can help reduce your taxes.
- If you use a corporation, you may qualify for the 20% deduction.
- If you use a corporation, other expenses may be deductible.
- If you hold the property for one year, you may qualify for long-term capital gains, which is either 15 or 20%. Be careful with this as you may have to rent out the house or meet other guidelines.
Depreciation on rental properties
The IRS treats the rental property as an asset that can be depreciated. They assume the rental property will slowly degrade over time until it falls down and is worthless. Most properties are not going to fall into a pile of rubble unless they are not maintained, which is very good for rental property owners.
The IRS says a house will last 27.5 years, which means an investor can deduct the cost basis of the rental property in equal increments over 27.5 years. To calculate the amount that can be depreciated, divide the cost basis by 27.5. That is your deduction for the next 27.5 years. For example:
- A property is bought for $150,000, but the structure is worth $120,000.
- The structure can be depreciated over 27.5 years.
- $4,364 can be deducted from your income, which can result in thousands of dollars in tax savings each year.
For commercial properties, the property is depreciated over 39 years. There was talk that the new tax law would reduce both residential and commercial depreciation to 25 years, but this clause did not make it into the final bill.
Cost basis on rentals
The cost basis is the cost of the rental property and only includes the structure of a rental property, not the land. If you buy a rental property for $100,000 that is on its own lot, the entire $100,000 is not the cost basis. You have to deduct the value of the land from the purchase price, and then you have a starting point for your cost basis. You can also add many of the closing costs like abstract, title, recording, and other fees to the cost basis. The entire list can be found on the IRS website.
If you depreciate a rental property over 20 years and sell the home, you could have a large tax bill from the IRS. The depreciation on rental properties must be recaptured, which means you have to pay back all the taxes you saved with the depreciation deduction. The depreciation is only recaptured if you sell the asset for at least the amount of your cost basis minus the depreciation.
Even though you have to pay back those tax savings, it is still better to pay those taxes 20 years down the road instead of now. With inflation, money is worth less in the future, and you can also invest that money for 20 years until you have to give it back to Uncle Sam. Think of it as a no-interest loan from our government! You also may be paying a lower tax rate on depreciation recapture than you would on ordinary income depending on your tax rate. The depreciation recapture rate is 25 percent, whereas ordinary income rates can be much higher. There are also many ways to avoid depreciation recapture.
Taxes on rentals when selling
- The easiest way to avoid paying back the tax savings is to keep the rental property and never sell it. You can refinance the property and take money out with a new loan without paying taxes.
- Another way to avoid the depreciation recapture is to use a 1031 exchange. If you sell your rental property, the IRS allows you to exchange that property for a similar property without having to recapture any depreciation. Here is much more information on 1031 exchanges.
- If you happen to pass away while you own your rental properties; the properties will pass on to your heirs. When your heirs inherit the properties, the cost basis becomes the current value of the properties, not what the original owners’ cost basis was. That means there will be no depreciation recapture. Planning to hold your rental properties until you die is not a bad strategy tax-wise.
- When you sell a rental without using a 1031 exchange, the gain is usually taxed as a long-term capital gain which is either 15% or 20%. The gain is the profit from what you sell for minus what you bought for minus expenses that weren’t depreciated or deducted already. The loan or cash you get at closing has no bearing on the gain.
- Another way to defer the gain when selling a rental could be selling with an installment sale using seller financing or using opportunity zones.
The video below talks about opportunity zones.
What other expenses can be deductible on rental properties?
Not every expense on rental properties is deductible, but many are. Since rental properties are considered a business, travel expenses, accounting fees, management, and many more expenses can be deductible.
If you make repairs on your rental properties, they are deductible as well, but improvements are not. If you repair a leaky faucet, that is deductible, but if you add a second story, it is considered an improvement and not deductible.
Even though improvements are not deductible, that does not mean you can’t count them on your taxes. Improvements can be depreciated like the rental property itself. There are different amounts of time that improvements are depreciated over, ranging from 3 to 20 years. You won’t have to wait 27.5 years to see the full tax benefit of most improvements.
Maximum amount deductible on rentals
The IRS has different rules for those considered in the real estate business and those that are not. If you spend more than half your time on rental properties, you are considered to be in the rental property business. If you are in the business, there is no limit to the deduction or losses you can take on your rental properties.
If you are not in the rental property business, you can take a maximum of $25,000 loss depending on how much money you make. The more money you make, the less of a loss you can count toward your other income. The deductions and depreciation will still counteract the money you make on the rental properties, but it might not help reduce your regular income taxes.
Using corporations to pay fewer taxes
Most real estate investors use LLCs or S corporations to do business if they do not pay taxes as an individual. When you operate these types of businesses, the income passes through the corporation to the individual. The final tax bill included a 20% deduction for pass-through entities. That means that if you have a pass-through entity, you may pay 20% fewer taxes than you do now. There are some restrictions and please talk to an accountant for specifics.
When I was first buying rentals, my property taxes on homes that I bought from $80,000 to $140,000 were around $400 to $800 a month. But Texas may see property taxes 3 or 4 times higher than Colorado, and New Jersey has even higher taxes. When investing in real estate or buying a personal house, it is important to know what the property taxes are and how they affect you.
Some states have different property tax rates for investors and owner-occupants. South Carolina has a much higher rate than what is listed for investors. Below is a list of the lowest property taxes in the country.
|District of Columbia
As you can see, there are many states with even lower taxes than Colorado, but that is not all you can consider when looking for a place to invest. Hawaii has the lowest property taxes, but the cost of living is one of the highest in the country, and housing prices are astronomical. On the other hand, people see the price-to-rent ratios in places like Chicago and New Jersey and think rentals there would be a great investment. But Illinois and New Jersey have two of the highest property tax rates in the country. The states with the highest property taxes are listed below.
You may wonder why property taxes vary so much from state to state, but there is a simple explanation. Some states have no income tax, some have a high-income tax, some states have no vehicle taxes, and some states have no sales tax. When you are living in these states, the taxes are paid one way or another to the state. But when you are investing in rental properties from another state, you don’t care what the income or vehicle taxes are.
Breakdown of Tax Benefits
Alright, with everything above in mind, here’s the breakdown of real estate investing tax benefits.
Deductible Expenses: Reducing Your Taxable Income
Owning rental properties allows you to deduct many expenses incurred from your taxable income, effectively lowering your tax bill.
- Property taxes: These annual payments to the local government are fully deductible.
- Mortgage interest: The interest portion of your monthly mortgage payments can be deducted, offering significant savings, especially in the early years of ownership.
- Insurance: Fire, flood, and liability insurance premiums are all deductible expenses.
- Maintenance and repairs: Costs associated with keeping the property in good condition, such as repairs, replacements, and landscaping, are deductible.
- Depreciation: This unique benefit allows you to spread the cost of the property (excluding the land) over its useful life (typically 27.5 years) as a non-cash expense, even though the property’s value may be increasing.
Capital Gains: Enjoying Favorable Tax Rates
When you sell a property for a profit, the difference between the sale price and your adjusted basis (original purchase price plus improvements) is considered a capital gain. Compared to ordinary income, capital gains receive preferential tax treatment:
- Long-term capital gains: Profits held for more than one year benefit from significantly lower tax rates than ordinary income, falling into the 0%, 15%, or 20% brackets.
- 1031 Exchange: This powerful tool allows you to defer capital gains tax by reinvesting the proceeds from the sale of a property into a similar investment property within a defined timeframe.
Passive Income and Pass-Through Deductions
Rental income generated from your property falls under the category of passive income, meaning it is not subject to self-employment taxes like Social Security and Medicare.
Additionally, qualified business income (QBI) earned from real estate activities may be eligible for the pass-through deduction, allowing you to deduct up to 20% of your net rental income on your personal income tax return.
Tax-Advantaged Retirement Accounts
Investing in real estate through certain retirement accounts like Self-Directed IRAs provides additional tax benefits.
You can contribute pre-tax dollars, allowing your investments to grow tax-deferred until you withdraw them in retirement. This can significantly boost your long-term wealth accumulation.
Depending on your location and the type of property you invest in, various government programs and initiatives offer further tax breaks. These could include:
- Opportunity Zones: Investing in designated economically distressed areas may entitle you to significant tax breaks, including capital gains tax deferral and potential forgiveness.
- Historic preservation tax credits: Restoring and preserving historic properties can earn you valuable tax credits.
Using a Tax Professional
The tax benefits of real estate investing are huge. It’s worth hiring a CPA or qualified tax professional to make sure you’re getting as much benefit as possible Taxes are complex and the best strategies are tailored to your individual circumstances and investment goals.
Real estate has some amazing tax advantages, but it can be confusing and not always cut and dry. Always talk to an accountant or an attorney for specific advice. If you are looking to reduce your taxes, real estate can definitely help, but it can also make you a lot of money if you buy the right properties. The right corporate structure can also greatly help reduce taxes, so make sure you are not missing out by doing it all on your own.