Real Estate Investment: Taxes
In this world nothing can be said to be certain, except death and taxes.
Taxes aren’t going away anytime soon, so it is incredibly important to mitigate this expense as much as possible. Unlike other investment vehicles, real estate offers a wide array of benefits that can help you shelter your income and capital gains from taxes. Here are the top 6 tax advantages of investing in real estate:
Note: I am not a CPA, so be sure to reach out to a tax professional for additional information!
Primary Residence: If you own a property as your primary residence, you will be able to make the following deductions to reduce your taxable income and hence your tax liability:
Mortgage Interest / Points: Interest on your primary residence loan is fully tax-deductible, if you qualify. Also points paid to reduce the interest rate of your loan are also tax deductible in the year that they were incurred.
Real Estate Taxes and Insurance
Home Offices: If you have a qualified office in your home, you are able to deduct any expenses associated with maintaining the office: paint, upkeep, utilities, etc.
Moving Expenses: You may be able to deduct the cost of moving depending on how far your new home is from your previous.
Capital Gains: You are able to avoid paying capital gains taxes on $250,000 of gains if single and $500,000 of gains if married. In order to take advantage of this tax benefit, the seller has to own and occupy the home for 2 of the last 5 years. Contrast this with investing in the stock market. The current long term capital gains tax rate is 15% (this can change based on your income, but for the majority of us, it is 15%). If you had capital gains of $500,000 in the stock market you would owe Uncle Sam $75,000. More information on taxes here
Investment Property: If you are a landlord, you have the ability to deduct more expenses that are tied to your investment property.
Depreciation of Assets: As a landlord, you are able to take advantage of an accounting expense called depreciation. Depreciation allows you to defer taxes that you would pay on income today until a future date when you eventually sell the property.
Mortgage Interest/points, taxes, insurance: Similar to owners of primary residences, landlords have the ability to deduct interest, taxes, and insurance expenses from property income.
Repairs/Maintenance: Any efforts to maintain the current condition of the investment property can be deducted from income. While repairs include fixes to plumbing, HVAC, painting, etc., maintenance includes regular expenses such as landscaping, pest control, pool cleaning, etc.
Condo Fees / HOA
Travel Expenses: Any long distance travel to visit your investment property can be tax-deductible as a business expense (airline fares, hotels, 50% of meal expenses during long-distance travel).
Vehicles: If your vehicle is used for business purposes, you may be able to deduct actual expenses or use a standard mileage rate of 56.5 cents per business mile driven.
Property Management Fees: If you hire a property manager, all management fees are deductible.
Legal/Accountant Fees: If you hire an accountant or a lawyer, or incur court costs/filing fees (for evictions), you have the ability to expense these costs.
Office/Operating Expenses: You can deduct office space (either commercial or in your own personal residence) from taxes. Also any other expenses including pencils, pens, staples, envelopes, etc. can be deducted.
1031 Like-Kind Exchanges
Section 1031 of the U.S Internal Revenue Code allows investors to defer capital gains taxes on the exchange of like-kind properties. 1031 is only for investment properties, not primary residences. This rule allows you to swap one investment property for another that is of “like-kind” at the time of sale and defer paying capital gains taxes.
No FICA (Social Security and Medicare) Taxes
Income generated from your investment properties is not subject to FICA/payroll taxes that you pay if you own a business or work a 9-5 job. Social security is financed by a 15.43% tax on wages up to $118,500 (2016) with half paid by workers and the other half paid by employers.
Most of us work 9-5 jobs, work for someone else, and pay 7.65% for our payroll taxes. However, if you are considering starting a business as a sole proprietor, be prepared to pay the entire 15.43% on any wages you earn.
Cash Out Refinance
One of the greatest benefits of investing in real estate is the ability to refinance properties and pull equity out of them to invest in other subsequent investment properties. This can be done with no tax implications.
For example, you purchase a condo for $250,000 and put 20% down (the initial loan balance is $200,000). Over time you build equity in the property and pay the balance down to $150,000. In addition, the price of the condo has appreciated from $250,000 to $300,000. In other words, you have gained $100,000 worth of equity ($50k debt pay down + $50k price appreciation) in the property since you first bought it.
You can refinance your loan, take on $100k of debt, and cash out $100k to be invested elsewhere. This $100k is not taxed as income, because you eventually have to pay the money back.
Note: these are generic figures used to describe the concept, you would need to talk to a lender to get a better idea of how this can work with your particular financial situation
Step-Up in Basis After Death
I’m saving the best tax benefit of real estate for the last. We mentioned before that you can use depreciation to defer taxes that you would be paying on income earned in the present. We also mentioned that the 1031 like-kind exchange can be used to defer capital gains taxes that would have otherwise occurred upon the sale of your investment properties. You are deferring these taxes until a later date, but what happens if you pass away before paying these deferred taxes? Does Uncle Sam take the taxes out of your estate that you pass along to your family?
The answer is, NO! Your heirs don’t have to pay any of these taxes. This can amount to huge tax savings over a lifetime of investing.
Here is a brief example..
Say you purchase a property for $200,000 and you elect to depreciate the property over its useful life of 27.5 years. The accounting value (basis) of the property today is $200,000 and after 27.5 years, it will be $0. The fair market value of the property today is $200,000 and after 27.5 years it is say $600,000. If you were to sell this property in 27.5 years, you would pay a capital gain on the difference between the fair market value at the time of the sale ($600,000) and the accounting value (basis) of the property ($0). Assuming the long-term capital gains tax rate is 15%, you would have to pay Uncle Sam $90,000.
However, if you decide to pass the property on to your family after you pass away, your family members get what’s called a “step-up in basis.” In other words, the accounting value at the time of inheritance is $600,000 and the fair market value is also $600,000. If your family decides to sell the property at the time of inheritance, they do not incur any capital gain tax. They could alternatively continue your business and begin to depreciate the property again, this time at $600,000 to $0.
In other words, you don’t pay tax on $200,000 of income that you received over the 27.5 years and if your family follows in your footsteps, they won’t have to pay tax on $600,000 of income. Depending on income tax rates (which I expect to be higher at that point in the future), this is a HUGE savings and an amazing way to grow wealth over generations.
Reading about taxes can be like watching paint dry. It’s boring, but knowing about these benefits can shape the way you invest going forward. Good luck, and feel free to contact me at Kevin@thebarberagroup.com for more information!