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Real estate investing can be a very lucrative business and a means to build wealth over time. While real estate is known to provide stable cash flow and long term capital appreciation, it also comes with significant tax obligations. As a real estate investor, it is crucial to understand the various tax rules and have sound tax management strategies in place. This will help maximize your after-tax returns from rental income and capital gains on real estate investments.
In this comprehensive guide, we will explore different tax saving strategies that real estate investors can leverage to legally minimize their tax liability. We will look at strategies related to depreciation, repairs and improvements, taxes on rental income, capital gains taxes, and more. The strategies discussed here are based on US tax laws. International investors should consult their local tax advisors regarding applicable rules in their country or state.
By the end of this guide, you will have a solid understanding of the major aspects of real estate related taxation and how to legally reduce your tax bill using different deductions, tax credits and other strategies. Let’s start by first understanding the various taxes that apply to real estate income and gains.
Taxes on Real Estate Income and Gains
There are three main types of taxes that real estate investors need to plan for – taxes on rental income, capital gains tax, and depreciation recapture tax.
Taxes on Rental Income
Any net rental income generated from real estate rentals is considered taxable income and must be reported on Schedule E of your personal income tax return. Rental income includes all rental receipts less qualified deductions like repair costs, mortgage interest, property taxes, management/broker fees, insurance and depreciation.
The amount of rental income reported on Schedule E gets added to your other income sources like wages, interest, dividends etc. and taxed at your applicable marginal tax rate which can be as high as 37% for high income individuals. In addition, you may have to pay Self-Employment tax (SE tax) of 15.3% on your rental income if you are a sole proprietor or single-member LLC.
Capital Gains Tax
When you sell a rental property for more than what you paid for it (adjusted for appreciation, repairs, improvements etc.), you owe capital gains tax on the profits known as capital gains. Capital gains are typically long term if you held the property for over a year and short term if you held it for less than a year.
Long term capital gains from real estate are taxed at a maximum rate of 20% for high income individuals. Short term capital gains are taxed at your ordinary tax rate which can be as high as 37%. In some cases, you may qualify to exclude up to $250,000 ($500,000 for married filing jointly) in capital gains from the sale of your primary residence.
Depreciation Recapture Tax
When you claim depreciation deductions during the years of owning a rental property, you are deferring taxes to future years. When you sell the property, any depreciation claimed in excess of the actual depreciation needs to be recaptured as ordinary income and taxed at your regular tax rate of up to 37%. This tax is called depreciation recapture tax.
Strategies to Defer or Reduce Taxes on Rental Income
As a real estate investor, here are some effective strategies you can use to defer or reduce taxes on rental income every year:
Take Depreciation Deductions
One of the best tax benefits of owning a rental property is that you can claim depreciation deductions every year to offset rental income. Depreciation allows you to deduct a portion of the initial cost of buying a building, land improvements, and equipment over a set number of years.
For residential rental properties, you can depreciate the building value on a 27.5-year straight-line basis. Individual components of the property like furnaces, hot water heaters etc. can be depreciated over shorter periods. Land value is not depreciable.
Depreciation provides you with tax deferral by reducing your current year rental income and tax liability. While you pay depreciation recapture tax later, the upfront tax savings can be substantial. For a $300,000 rental property, annual depreciation would be around $11,000 which completely eliminates taxes on rental income for many investors.
Take Repair and Maintenance Deductions
Repair costs incurred to maintain the property can also be deducted in full in the year they are paid. This includes repairs to the roof, plumbing fixtures, appliances, windows, painting, landscaping, cleaning etc. Keep proper records and receipts of all repair expenses.
Furthermore, certain improvements may qualify as repairs if they do not materially add value or life to the property. For example, replacing a furnace of similar value qualifies as a repair even though it extends the useful life.
Rent Loss Deduction
In the initial years of owning a rental property, rents may not cover all the expenses resulting in a rental loss. Using a rent loss deduction allows you to use the excess expenses or losses to offset other income like salary, capital gains, interest or dividends. This can provide additional tax savings.
A maximum of $25,000 in rental losses can be used to offset non-passive income for active real estate professionals who meet certain tests. Passive losses in excess of income can be carried forward to future years when rental income increases.
Take Mortgage Interest Deduction
Along with itemizing personal mortgage interest on your primary residence of up to $750,000, you can also deduct mortgage interest on rental property debt of up to $1 million. This helps reduce your taxable rental income every year.
Points paid to obtain financing are also deductible in full in the year paid. Keep in mind interest becomes non-deductible when using loan proceeds for other personal expenses or non-income producing uses.
Take Property Tax Deduction
Property taxes paid on the rental property qualify as an itemized tax deduction each year. This can provide meaningful tax savings, especially in states with high property tax rates like California, New York, New Jersey etc. Paying property taxes on-time also avoids penalties.
Use a Section 1031 Exchange
A Section 1031 like-kind exchange allows you to sell a rental property and purchase another investment property of equal or greater value within strict timelines without realizing capital gains. The tax on gains is deferred until you sell the new replacement property.
This is a powerful tool to continuously exchange properties and defer taxes for decades. You can exchange across different asset classes like land, residential, commercial, storage etc. Doing multiple 1031 exchanges over the years can supercharge long term wealth growth.
Take Business Expense Deductions
Other qualifying business expenses directly related to operating the rental property can also be deducted to reduce taxes. This includes:
Professional fees like accounting, bookkeeping, tax preparation etc.
Insurance costs for liability, casualty and property insurance policies.
Travel costs to the property for repairs, maintenance, finding new tenants etc.
Advertising, promotion and marketing costs to lease vacant units.
Legal and professional fees related to rental operations.
Keep accurate records of all allowable business expenses to maximize tax savings every year. Consult your tax advisor to identify other costs that qualify.
Set Up an LLC or S-Corp
Forming a single-member LLC or electing S-corp status allows you to take advantage of additional tax benefits. This includes:
Writing off health insurance premiums as a qualified medical expense deduction.
Contributing to retirement plans like solo 401(k) and claiming up to 25% of profits as a tax deductible retirement plan contribution.
Paying yourself a reasonable salary to get payroll tax treatment (FICA savings) on distributions.
An LLC also protects your personal assets from rental property liabilities. Consult your CPA to determine which structure makes most sense for your situation.
Take State and Local Tax Deductions
State and local income taxes, sales taxes and property taxes paid on rental properties may allow for additional itemized deductions up to $10,000. Though the SALT deduction cap was reduced under TCJA, it still provides valuable tax relief in many high tax states.
Strategies to Defer or Reduce Capital Gains Tax
In addition to the strategies above, here are more tips to minimize capital gains taxes when selling rental properties:
Use a 1031 Exchange
As discussed earlier, a 1031 exchange allows you to defer 100% of capital gains taxes when exchanging one investment property for another of equal or higher value within 180 days. This is the most powerful tool to defer taxes on sale proceeds for perpetuity.
You can buy replacement properties across different states or markets to diversify your portfolio tax-free over the years. Just be sure not to receive cash from the seller or they may disqualify the exchange.
Take Selling Costs as Deductions
Selling costs like broker commissions, attorney fees, transfer taxes and other closing costs directly attributable to the sale can be deducted from the gross sale price to reduce taxable capital gains. Keep records of all sale related expenses.
Live in the Investment Property
If you live in a rental property for at least 2 years in the last 5 years prior to selling,
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