Tax Benefits of Real Estate Investing: A Beginner’s Guide

Have you ever wondered why so many people are jumping on the real estate investing bandwagon? While potential steady rental income and long-term appreciation of property are undeniable draws, there is another benefit that shouldn't be overlooked: tax advantages. In fact, a big percentage of real estate investors report tax benefits as a significant motivator for their investment decisions. This comprehensive guide will walk you through ways in which real estate can help you from a taxation perspective.

1. Depreciation

One of the most powerful tax benefits of investing in real estate is depreciation. But what does that mean? It lets you deduct part of a building's cost—excluding the land—against your income tax annually. It represents that bit of wear and tear a property undergoes over time.

Think of it like this: You buy a brand-new car. You wouldn't expect it just to hold its value, right? Real estate will work in much the same way. The roofs wear out, appliances have to be replaced, and generally, a whole property declines gradually. Depreciation allows for the cost of the building to be spread over its "useful life," as the IRS has determined. Now, here's where it gets exciting: The IRS creates an applicable life category for various property types. For residential buildings, the current life is 27.5 years. That means you can deduct part of the building's cost from your yearly taxes for over two and a half decades.

There are two significant methods of depreciation you can predominantly use: the Modified Accelerated Cost Recovery System and the Straight-Line Method. Using MACRS will allow a larger deduction in the first few years of ownership, while straight-line does so over the useful life. Consultation with a tax professional will help finalize the best method for your situation.

2. Common Real Estate Tax Deductions

Depreciation is just one of the powerful tools at your disposal. Some of the other standard deductions that real estate investors can leverage against their taxable income include:

• Mortgage Interest Deduction: Each year, you can deduct the interest paid on your mortgage loan. Especially during the early years of ownership, when you are usually paying more in interest, these deductions can be significant.
• Property Tax: The property taxes paid for your investment property are also permissible as deductions against income, thus helping reduce some of the continuous expenses related to real estate ownership.
• Operating Expense Deductions: These might include repairs and maintenance, property management fees, utilities, and even pest control services.

Keep in mind that it can be tricky with tax laws, and what can be deducted might change drastically depending on the specifics of your property and personal tax situations.

3. 1031 Exchange

One of the best things about real estate investing is the 1031 exchange, which allows deferral on capital gains tax from the sale of an investment property if you reinvest the proceeds into a new "like-kind" property.

Here's how it works: Say you have had a rental property over some years, and it appreciated. Ordinarily, when selling, you will owe capital gains taxes on the profit. But by using a 1031 exchange, you can delay paying that tax bill simply by reinvesting your entire sale proceeds in a new investment property considered "like-kind." 

Like-kind simply means that the new property to be acquired must be similar to the one being sold. An example would be the exchange of one single-family home for another single-family home but not a residential property for a commercial property since they are in different investment categories.

There are strict IRS requirements and regulations involved in any successful 1031 tax-deferred exchange. The following represent some of the essential highlights:

• A qualified intermediary must be used who acts similarly to that of a neutral third party holding your funds securely until the purchase of the new property.
• You have 180 days in which to purchase one of those identified properties.
• To eliminate capital gains tax, you will have to reinvest the entire net proceeds from your original property to a new one.

4. Opportunity Zones

This 2017 innovation program offers a unique set of tax incentives that fuel America's low-income community economic growth. You get numerous attractive tax advantages to invest in a Qualified Opportunity Fund.

If you take your capital gains from the sale of any asset—this could be stocks or real estate, for instance—and invest it in a QOF in 180 days or less, then you can defer capital gains taxes on that money until the later date: either when you sell your investment in the QOF or December 31st, 2026.

If you hold your QOF investment for at least five years, a percentage of your original capital gains can be excluded from your taxable income up to 10%. The exclusion increases to 15% if you have held the investment for at least seven years. For assets held in a QOF for at least ten years, any appreciation on your investment grows completely tax-free!

Not any neighborhood will do as an Opportunity Zone, however. State and local governments designate these areas, and they have to be lower income. The whole point is to drive investment into those communities which, economically, have been left behind for too long. Opportunity Zones are still a relatively new program, and with any investment comes inherent risk. Finding a reputable QOF with a strong track record is critical to this process.

5. Tax Benefits for Rental Income

Rental income is generally considered ordinary and is taxed at your marginal tax rate. This simply means that your rent income gets added to your other taxable income (wages, interest, etc.) and is taxed accordingly. The good news is that owning rental property comes not only with many potential deductions that can significantly reduce your tax burden but a host of others, too. Here are some key deductions to keep in mind:

• Operational Expenses: This includes repair works, property management charges, utilities if one pays for the tenant, and even pest control services.
• Depreciation: As indicated above, depreciation is subtracting the portion of a building's value—excluding the land it sits on—from your taxable annually. This can, hence be approached as a leading deduction, particularly for newer properties.
• Interest on Mortgages: The interest you pay on your mortgage loan can also be deducted. This deduction is beneficial during the earlier years of ownership when generally, the interest payments are higher. 

In some cases, your rental property could even produce a loss, depending on your particular situation and deductions you are entitled to claim. While tax losses cannot themselves be used to offset other income directly, they can be carried forward to future years when they may help reduce your tax in those years.

6. Pass-Through Deductions and Passive Income

Most real estate investors hold properties in "pass-through entities," strongly including sole proprietorships, partnerships, and S corporations. None of these types of entities pay income tax themselves. Instead, the profits or losses pass through to the individual owners, who report them on their tax returns.

One of the most significant advantages to owners of pass-through businesses is being eligible for the 20% Qualified Business Income deduction. This deduction will allow you to deduct up to 20% of the amount of qualified business income from the entity, resulting in a reduction in your taxable income. However, certain limitations and eligibility requirements apply to this deduction, so consulting with a tax advisor would be in your best interest. 

7. REIT Tax Advantages

Real Estate Investment Trusts (REITs) provide a way for one to invest in the real estate market without personally owning and managing properties. While not technically "real estate investing" in the traditional sense, REITs can still allow exposure to the real estate market and offer some distinctive REIT tax advantages. While traditional corporations would pay corporate income tax, most REITs are exempt. Of course, in return, it is obligated to distribute at least 90% of its taxable income to shareholders through dividends. This might be maximally efficient based on the taxation situation of an investor. 

There are two ways to classify REIT dividends: ordinary income and capital gains. The source of the REIT dividend will dictate how the owner classifies it. It should be noted that you won't benefit from depreciation deductions with REITs, as in the case of many other real estate investments. 

The Bottom Line

Real estate investing offers a wealth of excellent benefits that cut your taxes drastically. The tax implications of real estate investing can be complex and vary depending on your specific situation. These implications also vary from one individual case to another. Hence, it is critically important that you consult a qualified tax advisor so as to be clear and perfectly aware of where the tax benefits and priorities are toward your particular set of circumstances. 

Moreover, tax laws relating to real estate are subject to change.If you stay up-to-date with industry publications regarding real estate investment and changes issued by the IRS, that will keep you ahead of any probable tax law changes that may affect your investments.