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.
Actively investing in real estate means investing in properties in addition to your primary or secondary residence. There are several tax benefits to real estate investment properties. In this article, we’ll go over them and cap it off with a short discussion on the advantages of using a 1031 exchange.
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.
Unlike a primary residence, the mortgage interest deduction on a real estate investment isn’t capped at such a low level. Homeowners (primary residence) can take an interest deduction on a loan of up to $750,000. Thanks to the Tax Cuts and Jobs Act (TCJA), landlords don’t hit any limitations until they earn more than $25 million.
As an example of how the interest deduction impacts taxes, let’s say Joe owns a $500,000 property with a 4% mortgage, creating $20,000 a year in interest. The property generates $5,000/mo in rent or $60,000 per year. After subtracting interest ($20,000) from rent ($60,000), we get $40,000 in taxable income.
Of course, expenses need to be subtracted, and the tax system is progressive, but to keep things simple, we’ll use the $40,000 and a 25% tax bracket. Taxes on the $40,000 are $10,000. Without the interest deduction, taxes owed would have been $15,000 or $5,000 more.
Benefit #2: Depreciation
Next up is the tax benefit of depreciation. Depreciation is a capital expense taken over a 27.5-year time frame for residential properties and 39 years for commercial. 27.5 is the number of years the IRS considers the rental property to have a "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.
Depreciation is one of the largest expenses of a property. Being able to reduce taxable income by part of the annual capital cost outflow helps improve your annual bottom line.
You can begin taking depreciation once the property goes into service (i.e., you begin charging rent). Time fixing up the property without renting it doesn’t count. Some examples of depreciation include the cost of the property, replacing the roof, kitchen improvements, and adding a new room (but not fixing a leak).
Benefit #3: Step-Up In Basis To Heirs At Death
If you have a property with a large gain and pass away, fortunately for your heirs, they don’t have to pay taxes on the gain. For example, you bought a $100,000 property seven years ago, which is now worth $250,000. Upon your passing, your heirs receive the property. Do they owe taxes on the $150,000 gain?
No. The tax benefit to your heirs is called a step-up in basis. At the time of your death, the property was worth $250,000, which is the basis that your heirs step up to. The end result is that no taxes are owed by your heirs.
Tax Benefits Of 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.
A 1031 Exchange allows you to sell one property and buy a like-kind property of equal or greater value, and it comes with some great tax benefits. These benefits are mainly through deferral. By deferring taxes, the investor has more capital available for the replacement investment property.
- Deferral of taxes — gains on the relinquished property are deferred. This includes both state (for most states) and federal taxes.
- Deferral of depreciation recapture.
- Deferral of the 3.8% Affordable Care Act surtax.
- Impact on replacement property basis — The replacement property basis is the value of the replacement property minus the amount of gain deferred in a 1031 exchange. In the case of a loss, it is added instead of subtracted.
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.
Being aware of the many real estate tax benefits can help reduce your year-end tax bill. Getting the calculations and timing right, in the case of a 1031 exchange, is key to making the most of these benefits.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Examples are hypothetical and for illustrative purposes only.
Realized does not offer legal or tax advice. As such, this information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult with a qualified professional.
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