The Land Act of 1820 was one of America’s first solutions for motivating people to buy land in “The West.” By reducing the minimum price and size of a standard tract, the government made land ownership throughout the country accessible for average Americans—not just the wealthy.
Fast-forward to today, and Uncle Sam is still providing incentives to people who are willing to invest. In fact, real estate investment continues to be one of the top ways for Americans to build wealth. One of the reasons this is possible is because the IRS offers tax benefits that open up the possibility for “everyday” investors to grow their wealth. Below, I outline the tax benefits available for anyone considering investing in real estate.
Benefit #1: Mortgage Interest Deduction
The most basic tax benefit that almost every American homeowner is familiar with is the mortgage interest deduction. If you own rental property with a mortgage, you can deduct the associated interest expenses for the purpose of calculating your taxable income.
Benefit # 2: Depreciation
Next up is the tax benefit of depreciation. In accounting, depreciation is a method of allocating the cost of a tangible asset over its useful life. Some people think of it as a decrease in the value of an asset over time. But here’s the deal: real estate doesn’t decrease in value over time. To the contrary, it increases.
So how do you determine the “useful life” of real estate? The internal revenue code lets real estate owners deduct a portion of what they have invested in their real estate assets each year as an expense, even if you don’t have to pay out any more cash. It’s considered a “non-cash” expense and when figuring out your taxes, those are the best kind.
But there’s a catch with taking depreciation deductions—they actually get “recaptured.” Whenever you sell a real estate asset you’ll be liable for depreciation recapture taxes equal to 25% of the total amount of depreciation deductions you have claimed since you’ve held the asset. In a word: ouch. However, there is a way to put off this depreciation recapture tax.
Benefit #3: A 1031 Exchange
The biggest and most substantial tax benefit in real estate investing is the 1031 Exchange. By completing an exchange, you essentially defer the depreciation recapture taxes and capital gains taxes that would otherwise be due.The one downside though is that you have to follow the rules and timelines of a 1031 exchange established by the IRS. The rules aren’t hard, and anyone with investment property can do a 1031 exchange. The core idea behind an exchange is to use realized gains from the sale of your asset to invest in your next real estate deal. Remember though: a 1031 exchange doesn’t eliminate taxes—it simply defers them to a later date. But there is some good news: with some fairly simple real estate inheritance planning, you can transfer properties to your heirs tax-free.
At Realized, we make it our job to understand the tax benefits of real estate investing to ensure our clients find the best returns during their exchange. Call us at 877-797-1031 to find out more about how Realized can assist you with your exchange today.
What is a 1031 Exchange?
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