7 Tax Benefits of Real Estate Investing

Estimated reading time: 7 minutes

When it comes to real estate investing, acquiring properties is just the tip of the iceberg. 

The most successful investors care deeply about maximizing the performance of each property in their portfolio. Beyond rental income and property appreciation, there are a myriad of real estate tax advantages that savvy investors can utilize to build lasting wealth.

In this blog post, we’ll explore seven tax benefits of real estate investing that you may be able to capitalize on. Read on as we uncover tax deductions, credits, and tax-deferred strategies that may reduce your tax liability. 

Note: This article is for informational purposes only. It is not a substitute for professional advice from a certified financial planner or public accountant.

Table of Contents

• Take Common Tax Deductions
• Qualify for Capital Gains Tax
• Calculate and Take the Depreciation Deduction
• Open a Self-Directed IRA
• Reduce Self-Employment Tax
• Utilize a 1031 Exchange
• Invest in Opportunity Zones
• Capitalize on Real Estate Tax Advantages

1. Take Common Tax Deductions

Real estate investors have several tax write-offs available to them, helping to minimize taxable income and optimize overall tax efficiency. 

Here are some common expenses that real estate investors write off on their taxes to reduce their tax liability:

1. Mortgage interest
2. Operating expenses
3. Repairs and maintenance
4. Property management travel expenses 
5. Advertising costs 
6. Utilities and homeowner’s association fees
7. Property insurance premiums
8. Legal and professional fees necessary for the investment property

Of course, to benefit from these tax write-offs, it's vital to keep detailed records of all expenses. You should also consult with a tax professional to ensure compliance with tax laws and to maximize the benefits of available deductions.

2. Qualify for Capital Gains Tax Treatment

One of the simplest ways to reduce your taxes is to hold onto your investments for more than a year.

If you purchase a property and then sell it within 12 months, any gains from the sale will be taxed as ordinary income. However, if you hold onto the property for over one year, the sale will be taxed as a capital gain at capital gains tax rates, at least on the federal level.

At the federal level, most taxpayers will only be levied a 15% tax, with some even qualifying for a 0% tax rate.

However, keep in mind that many states impose capital gains taxes as well. For example, California makes no distinction between short-term and long-term capital gains. If you sell a property for a significant improvement, your tax rate could be as high as an additional 13.3%.

3. Calculate and Take the Depreciation Deduction

Depreciation is a slightly more complex tax deduction that allows real estate investors to recover some of the cost of their income-producing properties over time. 

Unlike many of the other deductions above, depreciation is a non-cash deduction, meaning investors don't have to spend money to claim it. Depreciation can help reduce taxable income and, consequently, the tax liability associated with investment properties. 

Here's how it works:

Depreciation is the process of allocating the cost of a property (excluding land) over its useful life. The IRS defines the useful life of residential rental property as 27.5 years and most commercial properties (classified as nonresidential real property) as 39 years.

Investors can deduct a portion of the property's cost each year as a depreciation expense on their tax returns. This deduction is based on the property's value, excluding land, and is spread out over its designated useful life.

The depreciation deduction directly reduces the investor's taxable income for each year in which it is claimed. This may result in lower overall taxes owed, providing a significant benefit for property owners.

Here’s a simplified example of how the depreciation deduction works in action:

Assumptions:

• Residential Rental Property Value: $400,000
• Land Value: $40,000 (assumed to be 10% of the property cost)
• Depreciable Value (Property Cost - Land Value): $360,000
• Depreciation Period (Useful Life): 27.5 years (for residential rental property)

To calculate depreciation, follow the five steps below:

1. Determine Annual Depreciation: Divide the depreciable value by the useful life to calculate the annual depreciation. In this example, $360,000 / 27.5 years = $13,090.91 per year.
2. Take Annual Deduction: As the property owner, you may deduct $13,090.91 as a depreciation expense on your annual tax return.
3. Calculate Tax Impact: Assuming a simplified marginal tax rate of 25%, the tax savings from depreciation would be: $13,090.91 * 25% = $3,272.73.
4. Cash Flow Improvement: Due to the reduction in your taxable income, you experience a cash flow improvement of $3,272.73 for the year due to the reduced taxable income.
5. Recapture Consideration: If you eventually sell the property for a profit on its adjusted cost basis, you may be subject to depreciation recapture. If so, taxes will be owed on that recaptured amount.

In this simplified example, the property owner benefits from an annual depreciation deduction of $13,090.91, resulting in reduced tax liability and cash flow improvement. 

Again, this is a simplified example. Actual calculations will vary based on specific details and tax regulations. Consult with tax professionals for accurate guidance tailored to your real estate investment scenario.

4. Open a Self-Directed IRA

If you’re looking for additional ways to increase tax-advantaged holdings for your real estate portfolio, you may want to consider a self-directed IRA (SDIRA).

These powerful investment accounts are exactly the same as an IRA at a bank or brokerage, albeit with one distinct advantage: you’re able to invest in any asset the IRS allows, including real estate.

While most IRAs limit your options to publicly traded securities, an SDIRA affords you total control of your tax-advantaged investment portfolio. 

While you can’t transfer your existing real estate assets into an SDIRA, you can unlock your existing retirement funds from an inactive 401(k) or IRA and channel those funds into real estate. 

The process is simple. Just open a new SDIRA, fund your account with a transfer, rollover, or contribution, and start investing.

5 Steps to investing in Real Estate with an SDIRA. Get your free copy now >

Depending on whether you opt for a traditional or Roth SDIRA, you can benefit from tax-deferred or tax-free growth. While SDIRAs offer potential tax advantages, you must follow the IRS rules and regulations to maintain the tax-advantaged status of assets held in your IRA. 

5. Reduce Self-Employment Tax

If you’re employed by a corporation or small business, chances are you’ve noticed that a substantial portion of your paycheck goes to FICA, a tax levied for Social Security and Medicare. For most earners, this rate comes out to 7.65%. Many employees don’t realize that their employer pays an additional 7.65% on their behalf, bringing the total to 15.3%.

If you’re self-employed, you are required to pay the employee and employer share of FICA, meaning you must cover the entire 15.3%. However, if you are self-employed as a real estate investor, you may benefit from a notable exception to this rule. 

Unlike most income derived from self-employment, rental income may not be subject to FICA taxes, depending on your situation.

6. Utilize a 1031 Exchange

A 1031 exchange, also known as a like-kind exchange, is a tax-deferred strategy that allows real estate investors to sell a property and reinvest the proceeds into another property of equal or greater value. By utilizing a 1031 exchange, investors can potentially reduce or defer capital gains taxes on their real estate investment properties.

When you sell a property and complete a 1031 exchange, the capital gains tax on the profit from the sale is deferred, not eliminated. This means you can reinvest the entire sales proceeds into a new property without immediately paying capital gains taxes.

To qualify for a 1031 exchange, the investor must identify a replacement property within 45 days of selling the relinquished property. In addition, you must finish the deal on the new property within 180 days of the sale of the previous property.

The replacement property must have a value equal to or greater than the property sold.

7. Invest in Opportunity Zones

Created by the Tax Cuts and Jobs Act of 2017, an Opportunity Zone is a designated area in the United States that is eligible for certain tax benefits. The goal of Opportunity Zones is to stimulate economic growth, job creation, and community revitalization in areas facing challenges.

Real estate investors can receive tax benefits by investing in Qualified Opportunity Funds (QOFs). QOFs are pools of money designated to invest in businesses or properties within Opportunity Zones. The tax incentives are primarily focused on capital gains. 

Investors may defer paying taxes on capital gains that are reinvested in a QOF within 180 days of the sale of an asset. The deferred capital gains are recognized either when the investment is sold or by December 31, 2026, whichever comes first.

Capitalize on Real Estate Tax Advantages

Real estate investments have long been one of the most trusted assets by experienced investors. These assets offer wealth-building opportunities in the form of consistent rental income, property appreciation, and strategic tax planning. 

Leveraging various deductions, such as property management expenses and depreciation, can effectively offset taxable income. Additionally, tax-deferment strategies like the 1031 exchange and opportunity zone funds provide avenues to delay or potentially eliminate taxes on capital gains.

Taking tax efficiency a step further, real estate investors can utilize an SDIRA to further reduce the impact of taxes on their real estate earnings.

Navigating this landscape requires a comprehensive understanding of these strategies, and seeking advice from a tax professional is essential to ensure optimal utilization of deductions and tax advantages. 

Want to learn more about how to invest in real estate while minimizing your tax liability? Browse our Learning Center. 

You’ll find informative blog posts like 6 Types of Real Estate Investments to Navigate the Housing Shortage and extensive webinars like Purchasing Your First Real Estate Property With a Self-Directed IRA.