Tax Benefits Of Real Estate Investing: What Investors Should Know

If you’re a real estate investor, you’ll incur many yearly expenses to run and maintain your rental property. However, each expense represents a potential tax deduction you can claim to offset some of the rental income you’ve earned. It’s important to learn as much as you can, prior to getting started, about the tax benefits of real estate investing. This can help you unlock highly beneficial tax savings.

Let’s take a look at the various real estate tax benefits that are available, as well as how and when to use them.

Are There Investment Property Tax Benefits?

You can certainly reduce your taxes by investing in real estate. In fact, in the world of real estate investing, having a rental property for rental income provides you with a double benefit – cash flow and tax incentives for real estate investments. These tax breaks apply to both single-family and multifamily rental properties.

Real estate investing can lower your taxes in several ways, which we’ll look at in greater detail in just a moment.

6 Tax Benefits Of Real Estate Investing

Tax benefits of real estate include deductions and write-offs, depreciation, passive income and pass-through deductions, tax incentive programs, a way to lower the amount owed in capital gains taxes and the absence of FICA taxes.

Now, let’s carefully review each benefit in detail. 

1. Deductions And Write-Offs

Real estate investors can take advantage of multiple tax deductions and tax write-offs. According to the IRS, the terms “tax deduction” and “tax write-off” are synonymous. That is, they’re expenses you can subtract from your income to lower the amount you owe in taxes. Below are some items that qualify for real estate investor tax deductions, or, to put it another way, as tax write-offs for real estate investors:

• Mortgage interest: Mortgage interest refers to the portion of a monthly mortgage payment that you pay out in the form of interest. Interest is the amount you pay your lender for borrowing money. You’ll get a statement from your lender showing the total amount in interest you paid on your loan over the past year. Note that for some people taking the standard deduction will make more sense than itemizing for mortgage interest.
• Property taxes: You can also deduct property taxes, which you pay based on your state’s assessment of your property.
• Property management expenses: If you live out of state or don’t handle your own property maintenance for other reasons, a property management company can take on the responsibility of finding tenants, handling repairs and collecting rent. You can deduct the amount you pay the property management company to render those services.
• Maintenance and repairs: Believe it or not, you can make tax-deductible home improvements on investment and rental properties. For example, you can deduct small purchases for items such as light bulbs and furnace filters, and you can also deduct major expenses such as those associated with a new roof or HVAC system.
• Business expenses: You can always deduct business expenses. These often include accounting fees, advertising expenses, office space, office supplies, internet expenses, any lawyer fees you incurred when purchasing your business and other costs of running your business. You can even deduct for having a home office.

The benefits of tax deductions might look like this: Suppose you have a rental property that generates a profit of $6,000 each year. Now, let’s assume you pay a total of $3,000 to cover the cost of having a property manager, replacing a water heater and providing a new light source for the front porch. Instead of paying taxes on $6,000, you’d pay taxes on $3,000.

2. Depreciation

The amount you can deduct depends on a few factors, including market value, the property’s recovery period and the method of depreciation used. The most common method is the modified accelerated cost recovery system (MACRS). However, you would be on the hook for depreciation recapture. If you sell a property at a profit, the IRS wants some of the money back that they allowed for depreciation. But if you sell the property at a loss, the depreciation recapture won’t apply.

3. Passive Income And Pass-Through Deductions

Passive income, or income you earn with minimal effort, includes rental property earnings. If you experience losses from rental property (through depreciation, for example), you can deduct up to $25,000 in passive losses against your ordinary income as long as your modified adjusted gross income (MAGI) is $100,000 or less. Limits apply to both single or married filing jointly filers.

The deduction phases out $1 for every $2 of MAGI above $100,000 until a complete phase-out occurs at $150,000.

Established with the Tax Cuts and Jobs Act of 2017, the pass-through deduction refers to owning rental properties as a self-proprietor or partnership (through an LLC or S corporation). The rent you collect each month is considered qualified business income (QBI). You can deduct up to 20% of the QBI from your real estate investments.

Be aware, however, that the pass-through deduction is set to expire at the end of 2025 unless Congress extends it.

4. A Way To Reduce Capital Gains Taxes

Capital gains tax, which comes into play if you choose to sell your property, refers to the income tax on the profit from the sale of real estate that appreciates while you own it. In other words, let’s say you bought a home 5 years ago for $300,000 and sold it for $350,000 – earning a profit of $50,000. That $50,000 profit would be eligible for capital gains tax.

Two types of capital gains tax exist: short-term capital gains and long-term capital gains. Here’s a quick synopsis of how both work:

• Short-term capital gains: When you sell an investment within a year of purchase, you’ll incur short-term capital gains. The tax rate you pay depends in part on your individual tax bracket (either the 10%, 12%, 22%, 24%, 32%, 35% or 37% bracket). It’s also based on your taxable income.
• Long-term capital gains: The long-term capital gains tax applies if you sell real estate you’ve held for over a year. Instead of following individual tax rates, long-term capital will hit 0%, 15% or 20%. The percentage it hits will depend on your income.

Holding your investment property for longer than a year can significantly impact your tax liability. For example, Sam makes $125,000 of income and they file single. Their short-term capital gains tax rate would be 24%. However if Sam held onto an asset longer than 1 year, they would pay 15% in long-term capital gains tax.

5. Tax Incentive Programs

Certain tax incentive programs can also help you save money. For the sake of some examples, let’s look at a 1031 exchange, opportunity zones and tax-free or tax-deferred retirement accounts.

1031 Exchange

A 1031 exchange allows you to swap one real estate investment for another. It also helps you defer capital gains tax and depreciation recapture to purchase another investment property.  

However, you must swap a property of equal or greater value to take advantage of a 1031 exchange.

Opportunity Zone Funds

The previously mentioned Tax Cuts and Jobs Act passed by Congress offers tax breaks to real estate investors who build or rent property in rural or financially distressed areas of the country.

Opportunity Zones provide tax advantages to investors who choose to defer taxation on capital gains by swiftly investing those gains into a Qualified Opportunity Fund (QOF).

Tax-Free Or Tax-Deferred Retirement Accounts

Tax-free and tax-deferred retirement accounts, such as health savings accounts (HSAs) and individual retirement accounts (IRAs), let you add alternative assets such as real estate. These often tax-deferred investments allow you to postpone paying taxes until later, perhaps when you retire.

Depending on the account, you may face contribution limits and restrictions on the type of assets you can hold in the account.

6. No FICA Taxes

The Federal Insurance Contributions Act (FICA) contains a combination of Social Security taxes and Medicare taxes. Both employers and employees pay the same amount for each – 6.2% in Social Security taxes and 1.45% in Medicare taxes.

Since the money they make isn’t considered earned income, real estate investors and rental property owners don’t have to pay FICA taxes as they would on the wages they earned for working a job as a W-2 employee.

The Bottom Line

Investors can use numerous real estate tax advantages to their benefit. These include deductions and tax write-offs, depreciation, passive income and pass-through deductions, potentially lower capital gains taxes, tax incentive programs and an exemption from the FICA tax. If you do your research and understand how and when to use these tax benefits, you could end up with a significantly lower tax bill at tax season.

Ready to buy an investment property and enjoy real estate tax incentives? Start the application process to see what you can qualify for.