One of the great advantages of real estate investing is the tax benefits.
Investors can intentionally structure their real estate investments to minimize their taxes on multiple forms of income, including real estate profits. But like so much of the United States tax code, the rules can get confusing quickly.
Before you dive headfirst into real estate investing, ensure you understand the tax benefits and rules to avoid handing Uncle Sam more money than required.
How the IRS Taxes Different Real Estate Income
Not all real estate income is created equal. The IRS taxes it differently depending on where it came from and how long you owned the property.
Short-Term Capital Gains
When you sell an asset for a profit within a year of buying it, you owe short-term capital gains taxes on the profit. The rule applies to any asset, from stocks to bonds to real estate.
For example, you buy a house for $100,000, put $50,000 into renovating it, and flip it eight months later, selling it for $200,000. If you incurred $15,000 in closing and carrying costs, you earned a total profit of $35,000. And the IRS takes a cut of that profit come tax season.
The IRS taxes short-term capital gains at the same rate as your regular income tax rate. If your short-term capital gains push you into the 22% tax bracket, then you pay 22% taxes on any profits that pushed you into that bracket.
Long-Term Capital Gains
When you hold an asset for one year or longer before selling, you owe long-term capital gains taxes on the profit.
The difference is lower tax rates. To encourage long-term investment in the economy, the IRS taxes long-term capital gains at a lower rate, usually 15% for middle-class earners and 0% for Americans earning less than $40,400 ($80,800 for married couples) in tax year 2021. Single Americans earning over $445,851 and married Americans earning over $501,601 pay 20% in long-term capital gains taxes.
Real Estate Dealer Income
The IRS classifies anyone in the business of owning property with the primary intent of resale as a dealer.
That changes how the IRS taxes you. It considers your investment a business and taxes your income as business income. That means you have to pay self-employment taxes (double FICA taxes) and can’t take advantage of tax tricks like deferring taxes using 1031 exchanges or installment sales.
The line gets blurry when it comes to flipping houses. Someone who flips houses full time and does a dozen deals per year definitely qualifies as a real estate dealer. Someone who works full time in an unrelated field and flips one house as a side gig usually gets away with classifying the flip as nonbusiness activity.
When in doubt, talk to your accountant.
The IRS taxes rental income at your regular income tax rate. However, real estate income investors still have plenty of tools to reduce their tax rates.
Pro tip: If you’re interested in becoming a real estate investor but haven’t bought your first property, consider Roofstock. Roofstock gives you the opportunity and tools you need to purchase turnkey rental properties all around the country.
Tax Benefits of Real Estate Investments
As you explore ways to lower your taxes as a real estate investor, remember all the tax benefits of investment properties.
Imagine you could deduct the purchase price of rental property from your taxable income every time you buy a new one.
You can’t exactly do that. But depreciation comes close.
When you buy a rental property, you buy two things of value: the land itself and the building that sits on it. Land doesn’t rust or crumble or become outdated, but the building does, so the IRS allows real estate investors to depreciate the cost of the building over 27.5 years.
Think of it as a tax deduction — but one you must spread over many years.
To spread out the deduction, divide the building cost by 27.5 and take that as a deduction each year until you’ve deducted the total cost of the building. You can also depreciate the cost of “capital improvements” — major renovations that extend the usable lifespan of the building.
However, when you sell the property, you have to pay the IRS back for depreciation recapture. Think of it as taking out a free loan from the IRS.
Fortunately, you can avoid or defer paying depreciation recapture through other techniques, like a 1031 exchange.
Abundant Tax Deductions
Real estate investors can deduct (or depreciate) every conceivable expense they incur. These deductions are “above-the-line” deductions that come off your taxable rental income. That is, you subtract them from your gross personal income before you even begin calculating the taxes owed, so they don’t require you to itemize your deductions.
A few of the most common examples of investment property tax deductions include:
- Closing Costs. You can deduct some closing costs in the same year, while you must depreciate others along with the cost of the building. Your accountant can review your settlement statement and tell you which is which.
- Mortgage Interest. You can deduct the interest you pay on the mortgage, reducing its net cost to you.
- Repairs and Maintenance. Repair and maintenance fees are also deductible. Just beware of the blurry line between “repairs” and “capital improvements.” Replacing a broken window constitutes a repair. Replacing all your windows to modernize and improve energy efficiency is a capital improvement, which you must depreciate over 27.5 years rather than deduct it in one year.
- Utilities. You can write off any utility bills you incur as a landlord.
- Property Management Fees: If you pay a property management company to handle your rental properties, you can deduct it.
- Property Taxes. Your real estate tax bill is another operating expense that comes off your net rental income. As business expenses, these differ from itemized personal deductions.
- Landlord Insurance. Landlord insurance is the equivalent of homeowners insurance but for your rental properties. However, unlike homeowners insurance, it covers only the building itself, not the belongings inside the property. If a fire breaks out, landlord insurance covers the cost to repair the damage to the building but not the tenant’s belongings — your tenants require their own renters insurance policy to cover those.
- Professional Fees. All professional fees, such as accounting, bookkeeping, and legal fees, are tax-deductible.
- Home Office. While no longer available to employees, real estate investors can still claim the home office deduction. Just make sure you follow the rules to the letter because the IRS treats this one as an audit trigger.
- Travel and Meals. Real estate investors can deduct for travel and meals incurred for investing-related reasons. Note that you can only take meal deductions when you visit a property you already own, and even then, you can only take 50% of the meal cost. But like home office deductions, these are risky-but-valid deductions. Keep flawless documentation.
No Self-Employment Taxes
Buy-and-hold (long-term) investors don’t have to pay self-employment taxes. Yet they can make the most of the tax benefits of being self-employed.
They can take those juicy tax deductions like the home office deduction, travel deductions, and meal deductions. Accounting costs, legal costs, professional costs — all tax-deductible.
And they can still take the full standard deduction.
20% Pass-Through Deduction
There’s a chance you can qualify for the 20% pass-through deduction as a real estate investor. It allows you to deduct up to 20% of qualified business income from your taxable business revenue. But the rules and applications remain complex years after the Tax Cuts and Jobs Act of 2017 (TCJA) that introduced it.
First, you must have “qualified business income” and earn less than the $157,500 income cap ($315,000 for married couples). Second, you must operate as a true business with no commingling of personal and business funds. That starts with opening a legal entity, such as a limited liability company (LLC), and a separate bank account for it.
But most vitally, you have to work as a true real estate investing business, with at least 250 hours worked during the year. And you have to be able to prove it with time reports breaking down each hour worked and what you did.
Talk to a tax professional before claiming this one.
Options to Defer Capital Gains Taxes
Real estate investors have a few tricks available to defer capital gains taxes. In some cases, they can delay paying them indefinitely.
Also known as seller financing, installment sales take place when you sell a property and finance the bulk of the sale for the buyer. In other words, they pay their mortgage to you directly rather than taking out a loan from a bank and paying them.
In doing so, you spread your taxable capital gains over many years rather than taking it all at once. That prevents your taxable income from jumping through the roof in a single year.
For example, you bought a property 25 years ago for $50,000 and have since paid it off in full. You sell the property for $300,000 in today’s market. If the closing costs and capital improvements cancel each other out, you earn a taxable profit of $250,000.
A middle-class earner would owe the IRS 15% of that ($37,500) in capital gains. A high earner would owe the IRS 20% ($50,000). And all of it would be due in your next tax return.
But instead, you finance the property for the buyer and spread those gains over the next 15 years. Depending on your income, that could keep your capital gains taxes at the 0% tax rate each year. Or it could keep some of it at 0% and push some over the limit to 15% — still leaving your effective tax rate lower.
Invest in Opportunity Zones
The TCJA created opportunity zones. Under the recent law, investors can defer or potentially avoid capital gains taxes if they immediately reinvest those gains in a qualified opportunity fund. These funds own and operate properties in economically distressed areas designated as qualified opportunity zones.
The longer you hold your shares in the fund, the greater the tax benefit. If you hold the shares for at least 10 years, you may be eligible to avoid capital gains taxes entirely.
But the original law puts a time limit on this tax strategy. To get the tax benefit, you must invest in a qualified opportunity fund before Jan. 1, 2027, under the current law. You also have to move your capital gains into one of these funds within 180 days of selling your old asset.
Do your homework on these funds before investing, starting with some of the IRS’s most frequently asked questions.
A 1031 exchange, or like-kind exchange, allows you to immediately move your profits from selling one property into buying a replacement property without paying capital gains taxes on your profits from the sold property.
Like-kind exchanges are useful for scaling up your real estate portfolio to earn more income from it. For example, as a young adult, you buy a small single-family rental property that yields $150 per month. A few years later, you’ve built some equity and your savings, so you sell it and put the proceeds into a three-unit property that yields $450 per month. Five years later, you do the same to upgrade to an eight-unit property that yields $1,500 per month.
And you do all that without paying a dime in capital gains taxes.
When or if you eventually sell your property and pocket the profits, rather than reinvesting them, you’ll owe capital gains on them.
Options to Avoid Capital Gains Taxes Entirely
Not every tax bill is inescapable. If you plan carefully, you can avoid capital gains taxes in some cases.
Death, Not Taxes
The simplest strategy is to avoid selling your income-producing assets.
You get to keep collecting passive income from these investments through your working and retirement years. When you die, the assets go into your estate. The capital gains taxes then become your heirs’ problem.
But it doesn’t always work like that. First, the cost basis for your assets typically resets upon your death. In the world of accounting, your cost basis is the amount you paid for an asset. It’s used as the baseline to determine your capital gains later.
Say you bought a property for $100,000, and the day you die, it’s worth $1 million. If you’d sold it while still alive, the cost basis would be $100,000 and you’d owe capital gains taxes on a $900,000 profit. After you die, the cost basis for tax purposes jumps to $1 million. So if your heirs sold it at that price, they wouldn’t owe any capital gains on it.
In fact, most estates don’t end up owing any federal estate taxes. In tax year 2021, the first $11.7 million in an estate is tax-free on the federal level, though some states impose their own estate taxes, even on smaller estates.
You also have options to pull equity from your property before you die.
Cash Out Your Equity With Loans
Perhaps you start looking at all the equity in a $1 million property you own and start seeing dollar signs. You want to spend some of it.
You could sell the property. But that leaves you with two problems: First, you owe Uncle Sam capital gains taxes on your profits. Even worse, you lose the passive income from that property — forever.
The solution? Borrow money against your real estate equity rather than selling. You don’t owe capital gains taxes. You don’t lose your passive income stream. And while your cash flow drops, you can at least deduct the mortgage interest.
The result is that you get to cash out your equity, and your tenants will then pay down your mortgage balance for you.
Move Into the Property for 2 Years
Homeowners get a special exemption from paying capital gains taxes when they sell their home for a profit.
Known as the Section 121 exclusion (or the primary residence exclusion), the first $250,000 in profits are tax-free when you sell your primary home. Married couples get $500,000 in tax-free profits.
To qualify, you must have lived in the property as your primary residence for at least two of the last five years.
Invest in Real Estate Through a Self-Directed Roth IRA
You probably already know how a Roth IRA works: You pay taxes on your contributions, but your asset growth and withdrawals are tax-free.
Most people simply open a Roth IRA through their stockbroker and buy stocks and bonds with it. But professional real estate investors sometimes go the extra mile and open a self-directed IRA.
In it, they fully control their investments and can invest in nearly anything they want. That includes real estate investments, such as rental properties.
But these accounts come with some extra costs and work compared to a free typical Roth IRA account. Only open one after you’ve cut your teeth as a real estate investor and know you can earn higher returns with your investment properties than the historical stock market average.
Tax Benefits for Flippers
House flippers don’t get most of the tax benefits granted to other real estate investors. They pay short-term capital gains taxes on their profits and may even have to pay self-employment taxes as a real estate dealer, depending on their volume.
They can take all the same deductions, for business expenses, like mortgage interest and closing costs. Plus, the riskier deductions, like meals, travel, and the home office deduction, are justifiable.
One strategy you can use to flip a house and avoid paying capital gains taxes is to do a live-in flip. That’s exactly what it sounds like: You buy a fixer-upper, move in, and gradually improve it while living there.
If you hold it for at least one year, you drop your tax rate from short-term to long-term capital gains. If you hold it for at least two years, you qualify for the Section 121 exclusion.
Real estate can earn investors returns through both appreciation and ongoing income. That income continually adjusts for inflation and grows in value over time, and the tax benefits only serve to accelerate those returns.
While the tax advantages of real estate investments can get confusing, investors can use tax strategies to reduce risk and improve returns. Just make sure you hire sharp tax advisors before trying to get too fancy with your tax strategy.