Tax Advantages of Real Estate Investments
Note: this is Chapter 3 of an entire guide on Why Real Estate Investing?
Ever wondered why multi-million or multi-billion dollar business owners and companies are able to effectively pay 0 taxes? It's not a mystery — it's tax incentives by the government!
As with any investment, real estate owners are subject to pay taxes, which usually falls into two categories. You'll pay income taxes on rental income and capital gains taxes on any appreciation. But don't worry, there's a number of tax incentives to help ease your operation along.
As a real estate owner, these are the most common tax incentives that you'll be able to take advantage of. Basically, this is how to maximize gain potential with free money (thanks Uncle Sam!).
This chapter will break down each in detail, but here's the list:
Deductions (this one is huge)
Depreciation
1031 Exchange
Deductions
Deductions are the primary advantage to owning a rental property. This basically allows you to decrease your rental income on paper by calculating the expenses you may incur while owning your rental income.
Owning a rental home is treated similar to owning a business. Below is a breakdown of the most common that you may encounter. Consulting a tax advisor may help reveal more nuanced deductions you may be able to take.
Loan Costs and Loan Interest is typically the largest deductible expense. When getting your loan, you typically pay origination fees. Moreover, every month, you pay a portion of your mortgage in principal and in interest. The interest can be deducted as an expense when completing your taxes.
Property Taxes are taxes paid to a local and/or state government which can range from hundreds of dollars to thousands depending on home value and locale. In your escrow document, you can find the amount owed. Even more nuanced, some local areas may have occupancy taxes which are typically for short-term rental properties. But these taxes are completely deducted.
Insurance Premiums refers to any insurance policies pulled out on a rental home. During the home-buying process, you may opt to purchase homeowners insurance, liability insurance, and more. These can be deducted as expenses. Moreover, once you begin to grow your real estate empire, you may hire employees whose insurance premiums are also deductible.
Maintenance and Repairs can also be deducted provided they are intended to keep your home in "rentable condition." Note that home improvements are typically considered under depreciation (discussed below) rather than as maintenance and repairs. You may also deduct labor costs if you hire a professional to do these for you.
Utilities like gas, electricity, water, heating, and air conditioning can be deductible provided you pay for them per your tenant agreement. If your tenant decides to pay for the utilities, these will add onto your income less the cost of the utility.
Legal and Professional Fees may also be deducted if they are purchased for your rental home. For example, you can deduct the cost of a tax advisor to figure all of this out. But you can't deduct the cost of the tax advisor for your personal taxes. If you purchase a home through Doorvest, you may also deduct our property management fee. This is likely to become a large deduction in the beginning year of your rental as you'll likely need to hire a real estate agent, lawyer, tax advisor, or more! Note: you cannot deduct the legal fees that are used to defend your property's title.
Travel and Transportation can also be deducted. So if you drive from your residence to your rental, you can deduct the transportation fee via the standard mileage rate which is 56 cents in 2021.
Office Space can also be deducted. You don't have to literally rent an office. You can deduct the a spare bedroom in your own home if it is dedicated as an office space. You may also deduct any office expenses (printer, computer, etc).
As with most things, it's important to have proof of these expenses. Maintain clear receipts and records of these costs and purchases in case the IRS decides to flag and audit you.
Depreciation
Depreciation is a type of special deduction that is utilized by huge companies like Apple and Amazon to tax away their investment in property.
The key part is "over its lifespan." This allows a person or company to pay for (depreciate) a business asset by spreading the cost of the asset over time rather than in a singular year. This is easier to understand in an example, so let's get into it:
Let's say that X company purchased a new building for $50,000 with an expected lifespan of 10 years. Let's also assume the building is worth $10,000 (called a "salvage value") after those 10 years. Instead of recording $50,000 as an expense in the year of purchase, they could instead record partial amounts. To calculate how much to depreciate each year, the formula is:
(Cost - Salvage Value) / Lifespan
So in our example:
(50,000 - 10,000) / 10 = $4000
This means that a business owner or company can record $4000 of depreciation expense each year, which lowers your income (and thus lowers your tax liability).
More specifically for real estate, the IRS deems that a single-family home can be depreciated over 27.5 years. Note: Moreover, the IRS will only allow you to depreciate the structure (the home itself) and not the land it sits on. For example, if the rental home you own has a structural value of $100,000, you can depreciate the $100,000 over a 27.5 year lifespan.
$100,000 / 27.5 = $3636
You will be able to depreciate $3636 of the structure each year. This would decrease your rental income and thus lower your tax liability.
1031 Exchange
AKA the "like-kind exchange" or LKE, this is a tax tool that allows you to defer capital gains taxes on the sale of an investment home.
Normally, if you sell an investment and make profit, you must pay capital gains taxes. Capital gains taxes are broken into two categories:
Short-Term Capital Gains Taxes applies to an asset owned for less than one year. These rates are equal to your income tax rate or tax bracket. The rates change each year, but the 2021 rates can be found in the table below:
Long-Term Capital Gains Taxes apply if the asset is held for over one year. These rates change from year to year, but the current maximum rate is 20%. This makes it extremely attractive to hold an investment for at least one year before selling considering short term rates are much higher.
However, using the 1031 exchange allows you to avoid all of this for a period of time which acts like a tax-deferral. Instead of paying capital gains taxes on the sale, you may use the capital "swap" for another investment property.
There are a number of rules that are discussed more in-depth via our Financial Analyst, James Kuttner in this article. However, here's the gist:
You can't receive the cash from the sale meaning an intermediary (usually an escrow company) will hold the cash for you.
You must tell this intermediary in writing specifying the property you intend to purchase within 45 days. Including up to three allows you to add a fail-safe.
You must close a new property within 180 days of the sale date of the old home.
The difficult part is abiding by sales and purchase dates. The advantage to using a service like is that Doorvest will work with Doorvestors to find an appropriate exchange property to ensure these deadlines are met.
Conclusion
These are the primary tax advantages to investing in real estate not found in other investment options like stocks and bonds. Using all three combined can lead to upwards of hundreds of thousands of dollars in your real estate investing lifetime, and it is highly advised to do so.
Note: This article is published for informational and educational purposes only. Doorvest does not provide tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
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