How Does Owning an Investment Property Affect Taxes?

Investment property taxes are complex, and you should always seek the advice of a competent professional. The application of taxes related to investment real estate is different from taxes on your personal residence or ordinary income. For example, consider the limitation on the SALT deduction created by the 2017 Tax Cuts and Jobs Act (TCJA). SALT (state and local taxes) was previously one of the most widely claimed deductions on itemized federal tax returns in the U.S. The TCJA limited SALT deductions to $10,000 for either single or married filers. This new limit precluded many taxpayers from deducting the property taxes on their primary residences from their federal income taxes, at least to some degree.

The Rules For Investment Property Are Different

In contrast, if you have an investment property, since you deduct the expenses associated with the real estate from the income for the asset, you can still subtract the property tax paid from the income earned. Here is an example:

You own a rental property that generates $24,000 annually in rental income. The expenses that you incur to support the property are as follows:

Property taxes: $3,000 a year

Mortgage: $12,000 ($7,000 interest and $5,000 principal)

Insurance and utilities: $5,000

The taxes, interest, and other operating expenses are deductible from the operating income to reduce the amount on which you owe taxes. In addition, again, as a result of the TCJA, in some circumstances, you can subtract 20% of the QBI (qualified business income) from your pass-through earnings. Some income limits apply to those who can take advantage of this deduction, so consult your tax professional. Like the other provisions of the TCJA, these will expire in 2026 unless extended or modified first.

What is Depreciation?

Deducting the property's operating expenses from the income is reasonably straightforward, but determining the value of depreciation can be more complicated. The depreciation process is how the IRS allows the investor to recoup the cost of assets that they have in service to earn business income. The basis (cost) of the property is depreciated (reduced) over the course of what the IRS considers to be its useful life.

The land itself does not lose useful life, but buildings do. The allowed standard depreciation period for residential real estate is 27.5 years, and for commercial real estate, it is 39 years. The investor can deduct the appropriate fraction of the value from the taxable income each year. Here is an example:

Suppose you have an investment property (commercial) valued at $200,000. If the appraiser values the building at $150,000 and the land at $50,000, the depreciable amount is $150,000. Divide that by 39, and the amount that you can deduct each year is $3846.15. Keep in mind that when the investor sells the property, the IRS will want to recover the amount they have allowed for depreciation (if the asset has actually appreciated, as is often the case.) To achieve that, the amount of the sales price that equals the total depreciated amount will be subject to a depreciation recapture rate of 25%.

Operating Income Versus Capital Gains

With real estate investments, operating income is only part of the tax environment. The investor should also evaluate the ramifications of potential value appreciation when they consider selling property and how that will affect their tax liability. You may want to plan ahead and consider possible mitigating strategies like a 1031 exchange.