Many real estate investors get involved with owning investment properties because they have a passion for real estate investing and want to utilize its potential investment property tax advantages. Some of these tax advantages are paper deductions that don’t affect cash flow, while others are real expenses that are incurred. This article will go through the various investment property tax advantages that come with owning real estate.
Expense Offsets
Some real estate investment expenses affect cash flow. For example, if a property makes $2,000 in a month and incurs various maintenance, insurance, and labor expenses, that $2,000 of cash flow will be reduced by expenses.
The reduction in income also reduces the annual tax bill. Less income equals less taxes to pay. Some real estate expenses that can be deducted include:
Operating Expenses:
- Loan Interest (i.e., mortgage interest)
- Labor (i.e., employees and contractors)
- Professional services such as legal, accounting, and property management
- Insurance
- Utilities (not covered by tenants)
- HOA fees
- Repairs and maintenance, although you’ll want to adhere to the betterment, restoration, and adaptation guidelines for differentiating between these two
- Home office
- Travel-related expenses to/from properties (i.e., mileage, rental car, hotel, flight)
Potential one-off or rarely incurred expenses:
- Casualty losses
- Broker commissions (tenant placement)
- Refinancing Cost
Working with a tax accountant can help ensure the right deductions are being taken, resulting in a potentially much smaller tax bill.
Depreciation
Some deductions do not affect cash flow. Depreciation is one of them. Investors can declare a depreciation expense on their tax return without it ever affecting cash flow. This is because there is no related offsetting cash flow expense for depreciation.
Depreciation is declared annually on the investor’s tax return. The amount that can be deducted is based on the adjusted cost basis of the property. The adjusted amount includes any property improvements.
For example, a property was purchased for $200,000 and $15,000 in improvements were added (new AC and kitchen upgrades). The adjusted basis is $215,000. Divide the adjusted basis by 27.5 years, which is the length of time that investors can take depreciation on residential investment properties:
215,000 / 27.5 = $7,818,18
The depreciation expense for this property is $7,818.18. That is an expense that can be declared on the investor’s tax return, reducing taxable income in the process. However, the investor’s bank account is not reduced by $7,818.18, making depreciation a paper expense.
There is more to calculating the adjusted cost basis. Some depreciation expenses can be taken fully in the year incurred. Working with a tax account is best for getting the calculation and deductions right.
1031 Exchange
Once a property is sold, taxes on the gain will be due. If the investor wants to take their proceeds, fewer taxes due, and purchase another investment property, they’ll have a little less capital to work with (because of taxes).
Savvy real estate investors know that a better route to acquire another investment property is the 1031 exchange. Instead of paying taxes on gains, investors defer those taxes, allowing them to use their full gain towards purchasing another property.
Real estate investing offers plenty of opportunities to take advantage of tax benefits. By working with their financial team, investors can utilize these tax benefits to reduce their overall tax bill.
