Real estate investing can produce robust returns, but higher income doesn’t always equal more taxes. While it’s rare to eliminate taxes, the tax benefits of real estate investing can reduce your tax burden. As a result, you can rent out apartments or sell real estate holdings without giving up most of your profits. Real estate investors can qualify for tax write-offs, pass-through deductions, incentive programs and other tax benefits. Consider working with a financial advisor as you decide whether real estate is a good investment for you.
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Tax Benefit of Real Estate Investing
Real estate investing can bring a host of benefits at tax time. Whether you invest in family homes or commercial real estate, the following elements of real estate investing can help you minimize your tax burden and receive a healthy refund when you file. Here are the six most common tax benefits of investing in real estate.
1. Real Estate Deductions
Real estate deductions are excellent for lowering your taxable income. These deductions typically apply to the costs of property management and business operations. Specifically, the following deductions can help you reduce taxes:
- Property taxes
- Mortgage interest
- Insurance
- Property management expenses, such as utilities and lawn care
- Building repair and upkeep
- Home office deduction
- Advertising
- Travel expenses
- Legal and accounting expenses
- Business equipment, such as laptops and printers
Because of the numerous deductions available, recording your relevant expenses is crucial. Claiming deductions is next to impossible without detailed records and receipts. Plus, an audit from the IRS will require you to produce proof of your deductions.
2. Depreciation
Investors can subtract property depreciation from their taxable income, meaning they receive a deduction for how buildings deteriorate over time. Specifically, you’ll receive depreciation for the lifespan of the building according to the IRS’s timetable. Currently, residential properties have a lifespan of 27.5 years and commercial properties have 39 years.
You can take a depreciation deduction each year based on the real estate you own. For example, say you own a commercial building valued at $500,000. The land it sits on doesn’t count. When you file taxes, you can divide $500,000 by the lifespan of 39, meaning your property receives an annual depreciation deduction of $12,820.
3. Capital Gains
Capital gains taxes come from selling real estate at a profit. These taxes fall into one of two categories: short-term and long-term. Short-term capital gains are those you make from assets held for less than one year, while long-term capital gains are profits from selling assets held for a year or more. Short-term capital gains receive no tax benefits because the IRS considers them regular income. So, short-term capital gains can make you jump multiple rungs in the tax bracket, raising your income taxes.
Fortunately, long-term capital gains create tax advantages. First, they receive a lower tax rate than short-term gains and don’t count as normal income. If you reap long-term capital gains, your profit will fall into one of three tax brackets: 0%, 15%, and 20%. So, if you’re married and filing jointly with an income of $89,250 or less for the 2023 tax year ($94,050 in 2024), you won’t pay a penny of taxes on long-term capital gains.
4. 1031 Exchange
If you sell an investment property you’ve taken depreciations for, you’ll have to pay capital gains taxes on the sale and income taxes on all prior depreciation deductions. However, you can avoid this tax, called depreciation recapture, by using the 1031 exchange.
This benefit allows you to defer taxes on real estate sales if you buy another investment property of equal or greater value than what you sold. You can take advantage of 1031 exchange rules as often as you like – but remember, if you take the cash from a sale or buy a less expensive property with the money, you will owe taxes.
5. Passive Income and Pass-Through Deductions
A pass-through deduction is available if you conduct your real estate business through a sole proprietorship, real estate partnership, LLC, or S corp. These pass-through entities enable you to deduct 20% of qualified business income from your taxes.
For instance, say you operate rental properties through a real estate limited partnership. You receive $25,000 of annual income from the business, meaning you can deduct $5,000 of income when filing taxes.
Remember, the pass-through deduction is part of the Tax Cuts and Jobs Act and will last until 2025. If the government passes no new legislation regarding this deduction, you won’t be able to use it after that year.
6. Self-Employment With the FICA Tax
Self-employed workers typically must pay 15.3% of their income for FICA taxes. On the other hand, rental income is exempt from this rule. Therefore, if you rent out properties, you receive an exemption from FICA taxes.
7. Opportunity Zones
The Tax Cuts and Jobs Act also introduced opportunity zones for real estate investors. If you sell real estate, you can delay capital gains taxes by investing in properties in communities experiencing economic hardship. These government-designated opportunity zones are often in need of better-paying jobs and development.
Investing in an opportunity zone will provide three tax benefits. First, you won’t pay capital gains taxes until 2026 or when you sell your investment. In addition, your capital gains will receive a 10% step-up in basis if you stay invested for five years or a 15% bonus for seven years. Lastly, you can eliminate capital gains taxes completely if you invest for at least 10 years.
8. Tax-Deferred Retirement Accounts
Another way to get into real estate investing is with a health savings account (HSA) or individual retirement account (IRA) that allows you to invest in real estate. These accounts allow you to defer taxes on investments until you withdraw money from them.
Other Ways to Minimize Your Tax Bill as a Real Estate Investor
Minimizing your tax bill goes beyond the deductions mentioned above. As a real estate investor, you can reduce income taxes with the following strategies:
- Open an IRA: As previously stated, an IRA can help you access real estate investments. In addition, it can reduce income taxes. Specifically, you can open a traditional IRA and invest pre-tax dollars, lowering your tax burden further. You can invest $6,500 in your IRA annually, meaning you can lower your taxable income by that amount. If you’re 50 or older, your IRA contribution limit is $7,500. As a result, you can offset real estate income by several thousand dollars each year.
- Contribute to a 401(k): Similarly, you can contribute pre-tax dollars to a 401(k) if your employer provides one. However, 401(k)s have a higher contribution limit than IRAs. You can contribute $22,500 to your 401(k), making it an excellent tax shelter. Plus, if you’re 50 or older, you can deposit another $7,500 in catch-up contributions. But remember that you’ll pay taxes on the money you withdraw from your 401(k).
- Consider Asset Location: You’ll typically have to pay taxes on real estate income the year you receive it. However, you can transfer your assets to financial instruments that shield you from taxes. As mentioned above, an IRA can delay taxes on real estate income until you withdraw funds during retirement. You can also purchase a life insurance policy or annuity to avoid taxes. Therefore, how you allocate your assets can diminish your tax burden.
Bottom Line
Real estate can be a lucrative investment without incurring heavy taxes. You can take numerous deductions to offset income, such as property management expenses and depreciation deductions. In addition, regulations like the 1031 exchange and opportunity zone funds can delay or even negate taxes. If you still have income left over after these deductions, you can use an IRA, 401(k) or another tax-advantaged financial account to further reduce taxes. Therefore, it’s crucial to familiarize yourself with these strategies and consult a tax professional to optimize your deductions.
Tax Tips for Real Estate Investors
- Afinancial advisorcan review your assets and ensure you’re not paying a nickel more in taxes on your real estate investments than necessary. Finding a financial advisor doesn’t have to be hard.SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals,get started now.
- Everyone’s tax situation is unique, and it can be challenging to tell if you need a tax professional. Whether you have questions about lowering income taxes or are unsure of the tax implications of launching a real estate business, it’s beneficial to work with a tax advisor.
- Need help calculating your capital gains tax bill? SmartAsset’s Capital Gains Tax Calculator can help you estimate how much you may owe on the profits from selling an asset like property.
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