These guidelines will help you get the most out of your CRE income.
Finding the best real estate investing tax strategies is a major objective for an investor and can make the difference between success and failure.
In today’s real estate market, it’s especially important to have good tax strategies for real estate investors when:
Facing these challenges, real estate investors could see diminishing returns and less income.
CRE investors in the United States already pay almost twice the property tax as the OECD average, according to the nonprofit Tax Foundation. They now also face the biggest property tax rise in five years.
Source: Tax Foundation
The smart investor, however, doesn’t just think of tax liability, they also understand the tax benefits they can use to keep their taxable income to a minimum.
According to Steve Byrne, Founding Partner of real estate investment company EquiSource, “Real estate investing can provide for significant tax benefits. The trick – and often the tallest hurdle – is identifying the available strategies and understanding how and when to use them.”
In this article, we break down the 12 most important real estate investing tax strategies, as well as the tax basics that every investor should know.
Table of contents
- Tax basics for real estate investors
- Income tax strategies
- Capital gains tax strategies
Read on to learn all about tax loopholes for real estate investors and property owners.
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Investing in real estate is about more than finding the right property and getting the best return on it.
As an investor, you run a business and pay taxes. That’s why you must understand your tax liability and know which types of taxes you face.
Let’s refresh our memories with the basics before we dive into the 12 most important tax strategies for real estate investors.
Having a CPA with a good knowledge of tax laws can mean the difference between tax avoidance and evasion. We advise you to do your real estate and property tax planning with a CPA before filing taxes – instead of risking a tax lien from the IRS.
You should also have a deep personal understanding of tax strategies to go along with the CPA’s advice. This will help with your general CRE investment strategies.
Steve Byrne recommends the following: “While retaining a knowledgeable CPA is recommended and will help alleviate the stress, having a general understanding of these strategies and a thorough record of your real estate investment-related expenses will aid in those conversations, minimize your CPA costs and make your tax filing much easier.”
There are plenty of strategies that can lower your taxable income, from depreciation deductions to leveraging tax-advantaged accounts.
Any serious real estate investor should know these 9 income-related real estate investing tax strategies by heart:
Deductions might be the biggest tax benefits for real estate investors. Your ability to deduct depreciation on properties as a property owner offers a major tax cut. The IRS allows you to do this on residential buildings over 27.5 years and commercial buildings over 39 years.
Bernard Reisz, Chief Education Officer at ReSure, a popular investor tax tool, says “Depreciation tax deductions are powerful tax saving and wealth building tools. They provide tax deductions for capital invested in long-life assets, such as real estate, even when these assets are appreciating in value!”
Let’s say you’re investing in a $500,000 residential rental property with $100,000 allocated to land value. You can then write off $14,545 (500,000 - 100,000)/27.5) per year in depreciation deductions.
Some properties are even eligible for 100% bonus depreciation, meaning the entire cost can be deducted in the year of acquisition.
But be aware of tax deductions if you’re planning to sell.
Joel Lee, Advisor and Tax Planner at Thorough Financial Services, advises this: “You can deduct the cost of buying and improving a rental property over its useful life, offering a significant tax benefit. However, depreciation recapture can increase your taxable income upon sale.”
Does 39 years sound like a long time for the depreciation of an investment property? Then you should use a cost segregation study to accelerate your depreciation deductions.
Doing a cost segregation study lets you depreciate qualifying elements and improvements faster – in 5, 7, or 15 years – rather than the regular 27.5 or 39 years.
Which components can be depreciated faster? Joel Lee gives us an example: “Focus on land improvements such as landscaping or outdoor lighting – these usually qualify for quicker depreciation than the building itself.”
“Cost segregation can help you front-load depreciation deductions and maximize your short-term cash flow,” Lee concludes.
Cost segregation studies are also powerful tax loopholes for realtors, who use this strategy to reduce clients’ tax liability and close more deals.
Did you know you can deduct many operating expenses as a rental property owner? Deducting these expenses reduces your total taxable rental income.
Here are a few deductible operating expenses:
When put together, these can add up to a significant sum and help lighten your tax burden.
Are you using a mortgage to finance a commercial property?
Then you’ll be happy to hear that the mortgage interest you pay is fully deductible. All other loan fees are capitalized and can be depreciated over the loan’s repayment term.
Let’s do the math: you take out a $300,000 mortgage at a 5% interest and with $6,000 in loan fees over 30 years.
That means you can deduct the annual interest payment of $15,000 and depreciate $200 ($6,000/30) of the fees yearly.
The IRS defines repairs as costs that keep your property in good operating condition. Capital improvements materially add value, prolong the property's life, or adapt it to a new use.
For instance, your HVAC system might be in need of repair. You could take this opportunity to upgrade to a newer, more energy-efficient system. In that case, it’s a capital improvement.
In practice, distinguishing between repairs and capital improvements can be hard. As the example shows, maintenance costs can become capital improvements when the project turns into a full-blown renovation that exceeds the fix.
Yet, it’s important to report this correctly – because while repairs are deductible, capital improvements should be depreciated.
When investing in new property, try getting creative in your tax savings. All kinds of tax incentives exist, for instance, that let you use public funds for construction.
"It's more expensive to build now than ever, so you need to be savvy. Using public funds means the potential is there," said Stash Geleszinski, Managing Director at Capstone, when interviewed about tax strategies. “Things like historic tax credits, tax abatements, TIF agreements, provide a subsidy to facilitate new construction.”
Geleszinski suggests investors look into these tax credits and abatements with someone who knows their way around public funds and the institutions involved.
“There are consultants that specialize in this,” he recommends. “Oftentimes, they’re former developers or other professionals who've worked in various stages of the development process.”
A self-directed IRA allows you to invest retirement funds into alternative assets like real estate while deferring taxes until retirement. This provides tax-deferred compounding of rental income and appreciation.
Be aware that self-directed IRAs have strict rules like transaction restrictions and business income tax considerations. Consult with your CPA before locking your retirement funds into real estate.
Establishing a legal entity like an LLC or S-Corporation can provide tax benefits for your real estate investments. These entities allow for pass-through deductions where income is only taxed once on your individual return, avoiding double taxation.
Besides saving on taxes, LLCs can also be used to easily pay earnest money online.
Rental income is considered passive income by the IRS for most real estate investors who don’t actively participate in the rental property. The advantage is that you’re exempt from FICA taxes (Social Security/Medicare) that active investors have to pay.
However, there are some tax implications to consider. Those qualifying as "real estate professionals" can treat rental income as non-passive, deducting losses against ordinary income but subjecting it to FICA taxes.
Most of the above strategies reduce tax liability to increase your tax-free income. In order to really start improving your bottom line, employ these powerful capital gains tax strategies.
Deferring capital gains tax becomes especially important when you consider the proposed tax law changes.
All the more reason to find capital gains tax loopholes for real estate investors.
Sometimes called a like-kind exchange, a 1031 exchange is a powerful tool that allows you to defer the payment of capital gains tax over a property sale by reinvesting the proceeds in another property.
Your reinvestment has to meet a few specific requirements for it to qualify as a 1031 exchange:
Meeting these criteria means you can defer short-term capital tax gains, reinvest in new property, and increase your investment returns.
Here’s another useful tax law to pay attention to.
The Tax Cuts and Jobs Act has established opportunity zones to spur investment in undercapitalized communities.
Qualifying investments must be made in designated low-income urban and rural areas. Like with a 1031 exchange, investing capital gains from another investment into an opportunity fund must happen within a 180-day window to reduce the taxable gain.
Joel Lee recommends investing in opportunity zones: “Make use of opportunity zones to invest in areas in need of economic development. These zones can offer substantial tax deferrals and exclusions regarding capital gains.”
“Furthermore,” Lee says, “investing through an Opportunity Fund in commercial real estate can be a smart move to ensure your gains are aligned with long-term investment strategies.”
Another powerful tool in a real estate investor’s arsenal, installment sales lets real estate investors receive the proceeds from selling an appreciated property over multiple years rather than a lump sum.
This allows you to spread out and potentially defer a portion of the capital gains tax liability.
The IRS taxes only the gain percentage from each installment payment as it's received, so a well-crafted installment sale could decrease your exposure to higher capital gains rates in any single year.
Using real estate investing tax strategies is crucial for locking in your profits – but none of those strategies matter if you can’t secure the right real estate.
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With funding at the ready and CRE deals lined up, you can then use the smart tax strategies you learned in this article.
