How Do Tax Deductions Work?

Tax deductions are important for individual taxpayers because they can reduce your overall taxable income, which in turn can lower your tax liability, or the amount of money you’ll owe to the Internal Revenue Service when you complete your annual tax return.

There are many different types of tax deductions available to individual and married tax filers, including:

• Charitable contributions
• Mortgage interest
• Child tax credit
• Medical expenses
• Gambling losses
• Student loan interest
• Home office deduction
• Contributions to IRAs and 401(k)s

Some of these deductions, such as home office, are only available to gig and freelance workers. Taxpayers also will have to determine if these deductions aggregate to a larger tax savings than the standard deductions available to married ($25,100 in 2021) and single filers ($12,550).

Real estate investors, meanwhile, can access some very important “built-in” tax deductions. This article takes a look at some of the tax benefits available to investment property owners.

Tax Deductions for Commercial Investment Properties

There are several ways real property investors can reduce their annual tax liabilities, particularly when they hold commercial real estate investments over a longer period of time. Here’s a rundown of four common tax deductions and tax shelters available if you own an investment property.

Depreciation. This is perhaps the most important tax deduction available to investors who own commercial real estate. The IRS allows these taxpayers to depreciate their real property assets over a 39-year span (it’s 27.5 years for residential properties). Depreciation is the “wear-down” of the physical asset, and 39 years is considered the usable life of commercial assets purchased after 1993.

Here’s how it works: Each year, investors can deduct 1/39th of the costs associated with acquiring and maintaining their investment assets. Investors can use this important tax deduction for the full basis of their investments.

Depreciation is usually reported on Schedule E of your tax return. In order to claim this tax deduction, you have to own the property, derive income from it, determine its useful life, which has to be more than one year. There are two different ways to calculate depreciation: General depreciation and alternative depreciation. Consult your tax professional to determine which system works best for your particular tax situation.

Real Estate Expenses. Many expenses incurred through real property ownership are tax deductible as well. These include:

• Mortgage and financing interest
• Travel expenses directly related to property ownership
• Home office deduction
• Professional services such as legal, accounting, and property management
• Insurance
• Utilities
• Repairs and general maintenance
• Broker commissions
• Refinancing costs

Many of these expenses are simple to determine, while others can be a bit more complicated. Relying on the experience of certified tax professionals with extensive knowledge of real property ownership tax laws and regulations can help ensure you take the proper deductions on your annual tax return.

Holding time. Holding time determines how capital gains are taxed when you divest investment real estate.

Short-term gains -- applicable for assets held less than a year -- are taxed as ordinary income. This rate could be as high as 37 percent depending on your income and filing status. Long-term gains -- applicable for assets held more than a year -- are either 0, 15, or 20 percent depending on your income and filing status.

1031 Exchange. Taxpayers who sell investment properties can defer their capital gains tax liabilities by rolling proceeds gained from the relinquished asset into a replacement property through a 1031 exchange.

There are many rules, regulations, and deadlines associated with 1031 exchanges, however, so if you plan on taking this direction, make sure you’ve mapped out an exchange strategy prior to close of sale on your original investment property.

The Bottom Line

Real estate investors can access some important tax deductions that can reduce their annual tax liabilities on investment properties, which can potentially preserve more of their wealth. However, accessing these deductions typically requires the help of qualified and experienced tax professionals so investors avoid costly mistakes and potential penalties.