The Tax Benefits of Real Estate Investing
Investing in real estate is a relatively easy and effective way to generate passive income. In order to optimize the income that you enjoy, however, it is important to fully understand the tax benefits associated with real estate investing and how you can take full advantage of them. To that end, here is a look at some of the top write-offs and deductions that can be utilized by real estate investors.
There are several different deductions that real estate investors can use to help reduce their overall tax burden. Some of the things that you can deduct include:
- Advertising costs
- Maintenance costs
- Mortgage interest
- Operating expenses
- Property tax
- Repair costs
All of these expenses are considered to be part of the ordinary and necessary expenses for conserving, managing and maintaining your property.
Depreciation is another deduction that you can take to help reduce your overall tax burden. Depreciation allows you to recover the costs associated with the general exhaustion or wear and tear of a rental property. Three factors determine the amount of depreciation you can deduct each year, including how much the property is worth, the recovery period for the property and the depreciation method used. Most investors use the Modified Accelerated Cost Recovery System, or MACRS, which allows you to deduct depreciation for 27.5 years with residential property and 39 years with commercial real estate. Even if the property produces positive cash flow, depreciation categorizes it as a net loss.
Capital Gains Exclusion
Capital gains refers to the profits that you make when you sell your property. They may be either short-term or long-term, with long-term typically being the best route for real estate investors. Short-term capital gains apply to properties that are held for one year or less, while long-term capital gains are made on properties held for longer. Long-term capital gains offers a more favorable tax rate while also allowing you to utilize all of the deductions as previously discussed.
To get the best tax benefits, you will want to look into obtaining a capital gains exclusion. A capital gains exclusion, which can be used more than once, exempts you from paying taxes on profits of up to $500,000 from selling your home. If capital losses exceed capital gains, you can also offset up to $3,000 of other income.
Self-Employment and FICA
According to the Federal Insurance Contributions Act, or FICA, a self-employed business owner is responsible for the full 15.3 percent tax that is typically split between an employer and the employee. Depending upon the legal structure of your real estate business, however, you may be able to offset this cost. To learn more, consult with a CPA with experience in setting up real estate investor business structures so you can get the greatest tax benefits possible.
A Section 1031 Exchange allows you to swap out one real estate investment asset for another without having to pay taxes on the transaction. This means you can roll over gains from one investment to the other, effectively allowing you to avoid taxes until you sell at a later date. The properties must meet certain criteria in order to be eligible for this tax benefit.