Of course, you’re going to want to seek the advice of a real estate tax expert but here is a primer on tax benefits that entice investors to make the decision that the real estate market has substantial advantages over other investment options.
Your first instinct might be that a tax related article is most appropriate shortly before tax day in April. However, tax benefits accumulate during the year making anytime a good time for real estate investing. Often, the best time is during the slow months (winter) when distressed sellers have fewer buyers bidding on properties.
Capital Gain Taxes Are Not All Created Equal
What experienced investors already know and new investors need to be aware of is there are generally two capital gain tax rates. Capital gain is realized when you sell an investment property. Capital gain is the amount you profit from a sale after first deducting all of your expenses related to your investment property. You’ll want a tax expert to help you make sure you have captured all expenses before calculating your capital gain.
Short term capital gain is applied to an investment property that is bought and sold in less than 12 months. Short term capital gains are taxed at your personal income rate. Long term capital gain tax is typically the strategy followed by landlords. Long term capital gain is much more favorable for investors as it’s a much lower tax rate than a short term gain.
If you are tax-sensitive, the long range investment strategy works in your favor. And you can still use other tax deductions to further reduce your tax liability. A tax strategy that some investors use is to make the rental property their primary residence for a period of time before selling. If the house has been your primary residence for 2 of the past 5 years, the first $250,000 (for single people and $500,000 for a married couple) is free of capital gain. Before the Taxpayer Relief Act of 1997, this capital gain tax break was only available once in a lifetime and you had to use the profit to invest in another home. Today, you can use this tax clause as often as every two years and the profits don’t have to be reinvested in another primary residence. See your tax advisor for specific details.
Deductions and Depreciation
Real estate investing is full of tax advantages. Too many tax breaks and too many details for this article to fully cover. Others include:
- Depreciation involves recovering the cost of income producing property (no raw land) through yearly tax deductions. For rental homes, this is generally accomplished over 27.5 years and 39 years for commercial real estate. Depreciation is a big motivator for real estate investors.
- Other deductions include costs associated with mortgage and other business related interest, property tax, operating expenses, maintenance, and repairs. Keep records for maintenance and repairs separate from improvements to the property because these are treated differently for tax purposes.
- The Federal Insurance Contributions Act is a 15.3 percent tax that is split 50/50 between an employer and the employee. If you are the sole employee of your business, you could be responsible for the full amount. However, depending on how you legally structure your real estate business, this tax might be offset.
- Section 1031 of the Internal Revenue Code allows a swap of one real estate investment asset for another. While most investments are taxable when sold, a 1031 Exchange will have no tax when structured correctly. This can be a great way to increase your asset wealth without incurring taxes. There are many variations to 1031 Exchanges and professional assistance is a must.
As a real estate investor, it’s critical that you become familiar with the many tax benefits that you are entitled to that might not be available to other investors. The obstacle for many is understanding what is available and how to take advantage of these and other tax breaks. That’s where a real estate tax professional becomes invaluable to you. Done right, real estate investing leads to long term wealth by sheltering your income from Uncle Sam.
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Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 10 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. With the Pacific Ocean a couple of miles in the opposite direction.