It’s no secret that owning real estate is a terrific way to lower your tax liability and generate wealth. Notably, those investors who have learned to maximize their tax deductions are amongst the wealthiest in the country. For the most part, real estate income is taxed in a few different ways. First, real estate can be taxed as passive income (this is the most common way). Next, real estate income may be taxed from a W2 job or a business. Lastly, real estate income may be taxed from an investment portfolio, including stocks, bonds, REITs, etc.
For the most part, real estate income is typically classified as passive income unless the investor qualifies as a real estate professional and, according to the tax code, materially participates in their real estate business. Passive income is not subject to FICA tax like earned income is. FICA is comprised of Social Security and Medicare, which total 15.3% of your income.
In addition, real estate profits are also taxed if the property is sold for more than the purchase price (i.e., capital gain taxes). Below we will discuss strategies for investors to lower their annual taxes and any capital gains taxes when they sell their property for profit.
Arguably the number one way to reduce real estate taxes is to deduct depreciation on your taxes. Depreciation accounts for and deducts the wear and tear of your property over time. The Internal Revenue Service (IRS) sets depreciation at 27.5 years for a residential property since there is no objective way to determine a property’s lifespan. Specifically, depreciation is a paper loss, unlike other standard business expenses. What this means is that while you enjoy the benefit of the loss on paper, you don’t actually spend any money.
Overall, depreciation can be used to offset taxable income and save a real estate investor substantially on their tax bill. For the most part, the higher your tax rate is, the more you will save by depreciating your income.
If You Plan to Flip A Property, Live In It First
One popular way to avoid capital gains tax when you flip a property is to live in it initially. For example, you can move into your property shortly after buying it and make it your primary residence. The IRS states that as long as the home is your primary residence for two out of five years, you can enjoy a tax-free profit of up to $250,000 as an individual or $500,000 as a couple.
The 20% Pass-Through Deduction Pursuant to the Tax Cuts and Jobs Act of 2017 (TCJA)
Under the TCJA, taxpayers and real estate investors who generate qualified business income (QBI) can benefit from the QBI deduction. Essentially this means that real estate investors can deduct 20% of their income generated by their real estate business from any taxable income from that tax year. For example, if your business nets $100,000 for that tax year, you may deduct $20,000 from your net income making your taxable income $80,000 instead of $100,000. There are other specific criteria that investors must review with their accountant to determine if they qualify for the deduction pursuant.
Consider a 1031 Tax-Deferred Exchange to Avoid Capital Gains Tax and Tax-Free Growth
When it comes time to sell your investment property, you can avoid capital gains tax by utilizing a 1031 tax exchange. A 1031 exchange allows investors to exchange one property for another like-kind property without paying ANY capital gain taxes. There are very explicit rules regarding what type of properties qualify for a 1031 exchange with strict timelines. However, if the investor qualifies, a 1031 exchange is beneficial because it allows investors to retain 100% of their profits from selling their property and reinvest it into another property. Thereby enabling real estate investors to grow their portfolios tax-free.
Maximize Your Standard Tax Deductions
Generally speaking, maximizing your annual tax deductions is a great way to lower your tax bracket, which in turn reduces your tax obligations. There are several ways you can do this, including but not limited to the following: Property Taxes
– You can deduct your property taxes on your tax returns. Mortgage Interest
– Deduct mortgage interest paid on an investment property during the tax year. Maintenance Cost
– It is essential as an investor to keep good records to take advantage of every tax deduction that you are eligible for. For example, if you have to replace a tenant’s toilet, this replacement is deductible. Regular and Ordinary Property Expenses
– The normal, regular, and ordinary expenses related to managing and overseeing your investment property are typically 100% tax-deductible. For example, common expenses include property management fees, landscaping fees, ordinary repairs to your investment property, legal and accounting fees.
Overall, real estate is one of the best vehicles to create generational wealth. However, just like any other investment, avoiding taxable income is a terrific strategy for maintaining wealth. If investors can make optimal investment decisions and shelter their wealth from excessive taxation, they will achieve financial freedom in no time.
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