Investing in real estate? Don’t miss these 6 tax benefits
January 22, 2024
There are obvious benefits to investing in real estate—the potential for significant returns being one of them. But there are some lesser known benefits and incentives as well. These include several tax benefits that are unique to real estate investments.
Whether you’re a brand new or seasoned real estate investor, it’s important to know which tax benefits are available to you. Here are six tax benefits you should keep in mind.
Tax deductions for depreciation and mortgage interest expense
Depreciation expense is the tax benefit the IRS allows you to capture on the cost of any real estate you own. Residential property, for instance, is depreciated over 27.5 years. In the current tax environment, there are several opportunities to accelerate this depreciation deduction and claim over a much shorter life or immediately in the year of acquisition.
One thing to note: This is a largely a non-cash deduction as most of the cost basis of the property that is being depreciated is financed on the front end of the project.
You also can deduct the interest expense you pay on any mortgage for tax purposes. The principal portion of mortgage payments is not deductible; however, depreciation expense is the offsetting solve for a deduction.
After accounting for depreciation, mortgage interest, and the other operating costs of the property, most real estate projects result in tax losses for at least the first few years of operations. When shared among your fellow investors, these can potentially be used to offset other sources of your personal income.
Tax-free appreciation and cashflow
Because of the beneficial tax deductions mentioned above, even strongly performing properties with positive cashflow from operations can generate tax losses because of the non-cash expenses such as depreciation.
To explain: Assume a property has operating income of $100,000, depreciation expense of $200,000 and generated free cashflow of $50,000 which was distributed to the owners of the property. This property will report a $100,000 tax loss for the year after subtracting depreciation expense from operating income. Because a tax loss was generated for the year, the excess cashflow distributed to the owners will generally have no associated tax liability, which means the cash will be received on a tax-free basis.
To sweeten the deal even further, not only can this cash be realized on a tax-free basis, but as the property is held and its value appreciates, there is no tax liability associated with the increased value until the property is eventually sold.
If your property’s value appreciates enough, you could explore opportunities for refinancing your debt. This will generally result in excess cash being received on the refinance. Depending on your specific situation, cash from this refinancing could also be distributed to investors in a tax-free or very tax-efficient way. This allows investors to reap some of the benefits of the appreciation on the property without actually selling the property itself.
Preferred capital gains tax rates upon exit
When a property is eventually sold, most of the gain from sale is taxed at preferred federal capital gains tax rates. The highest federal capital gains tax rate is 20%; however, most investors will also have to pay net investment income tax (NIIT) which is an additional 3.8% tax.
Any depreciation expense you claimed on the property will likely need to be recaptured upon its sale, but even income associated with the previous depreciation claimed is generally taxed at a max federal rate of 28.8%.
As discussed above, because of depreciation expense and other tax deductions properties can often generate taxable losses. These annual losses create ordinary tax losses that, subject to limitations, will offset other ordinary income you may have individually.
The ordinary income that your property’s tax losses can be used against could be subject to tax rates as high as 40%. This means you and your investors may see as much as a 15–20% tax rate swing in your favor resulting from the tax savings at ordinary rates and the taxable gain at sale being realized as the preferential capital gains tax rates.
20% business income deduction
Although most properties generate tax losses, if yours were to generate taxable income from its operations, you and your fellow investors would be eligible for the 20% business income deduction. This deduction can be claimed on several different types of business income, including rental income. The result of claiming this deduction: you’re taxed on only 80% of the income allocated to you.
When comparing real estate investments to other types of investment opportunities, most will return interest, dividends, or capital gains income—yet only real estate investments are eligible for this 20% deduction.
A common tax strategy currently available only to the real estate industry is tax-deferred 1031 exchanges.
A 1031 exchange allows you to sell property and acquire new property in a tax-free manner. This is done by rolling forward the proceeds from the sale as well as taking on equal or greater debt.
This gives you an opportunity to diversify your real estate portfolio (you can exchange nearly any type of properties), take advantage of high property values on real estate you hold, or acquire multiple properties in exchange for selling a single property.
Newly expanded energy tax credits
Thanks to the Inflation Reduction Act, real estate investors can now benefit from newly expanded energy tax credits. Many of these credits, such as the 45L home energy tax credit, had existed for years; the Inflation Reduction Act simply enhanced their benefits.
These credits may be especially beneficial for larger types of real estate—and are yet another tax benefit unique to real estate investments.
How could these tax benefits apply to your real estate investments?
Investing in real estate could allow you to take advantage of several valuable tax benefits. But before you get involved in a project, it’s important to know how these benefits would apply to your situation.
If you’re considering real estate investments and would like to explore your options, the real estate tax experts at Abdo can help. We’ll shine a light on how each incentive can benefit your property or personal situation, giving you confidence for your next steps.
If you’d like to learn more about available tax benefits and how they could apply to you, contact us today.