People make investments because they want to grow their financial assets. Whether investing in stocks, bonds, or real estate, individuals learn to devote their limited resources to different investment vehicles for huge potential profits. But one of the factors that people often overlook when investing is the significant impact of taxes on their rate of returns.
Taxes can cut into the profits on any investment, which can put anyone’s investing goals at risk. Real estate investing is not an exception, although it’s considered one of the best ways to build wealth and reduce taxes. If you want to make significant savings on your real estate taxes, implementing some management strategies is essential.
To help you boost long-term returns, we’ve highlighted the top ways to lower your taxes as a real estate investor.
Utilize The Depreciation Method
Depreciation in real estate is a deduction that property owners can access to calculate the average wear and tear on an asset over a certain period. The Internal Revenue Service (IRS) sets the lifespan of such properties since there’s no way of determining how long a property will be usable.
A residential property can be depreciated over 27.5 years. For commercial real estate, it will take 39 years. If you purchased a residential property for $250,000, you would be able to deduct $9,090 ($250,000 divided by 27.5) for depreciation each year on your taxes. You can also depreciate capital improvements like putting on a new roof or renovating a kitchen.
However, you cannot include repairs that are essential to keep the property usable as capital improvements. It’s also worth noting that your investment property needs to be available as a rental to be depreciated. Even if the property remains vacant, you can take a full year’s worth of depreciation provided that it is available to rent all year.
Another vital thing to consider is the depreciation recapture. Once you sell the depreciated rental property, you’ll owe taxes on the profit you earn from it. You need not worry about such taxes, though, if you don’t consider selling the property.
Do A Live-In Flip
With a live-in flip, you live in your investment property for a certain period while you make some improvements. You are exempted from paying capital gains taxes once you sell the property as long as you lived in it for at least two of the previous five years before the sale. But like all other tax breaks, live-in flipping also comes with limits.
If you’re single, the tax exclusion limit is $250,000, while it’s $500,000 for married couples. Moreover, you can only do one live-in flip every two years to save on your taxes, unless you’re active-duty military, obliged to move for work or have health issues.
Live-in flipping may not be ideal if you prefer to live in your home for a much longer period. With this real estate investing strategy, you would have to move about every two years. But it can be an enjoyable way to earn money tax-free if you’re into home improvements. You just have to ensure not to pay too much that you’re losing more money on improving the home.
Offer Seller Financing
Offering seller financing to the buyer of your property is another way to save money on your taxes. Because when you sell a property with seller financing, you’re making an installment sale. It means that the buyer gives you a down payment and pays down the remaining balance regularly over the contract’s life.
So instead of paying hefty taxes in a single year, you only have to pay income taxes on the down payment and principal the buyer pays you. Thus, it allows you to realize the gain and spread out the tax over many years. As you receive the income, you pay a much smaller amount of taxes every year. But the risk in seller financing is the buyer may incur defaults.
That’s why you need to consider first if it’s worth giving up the lump sum you could get from traditional selling for the additional tax breaks. However, note that although you’ll pay the same amount of money in capital gains taxes, either way, you could earn more interest from the buyer when you make an installment sale.
Maximize Tax Deductions
There are tax deductions available for investors. If you want to lower your tax bracket, maximizing such tax write-offs will be a significant help. The following are a few of the deductions you can take advantage of as a real estate investor:
As an investor, you can deduct the interest you pay on your mortgage, whether it’s on your primary or secondary residence. If you used money from a loan secured by a mortgage for your business, you could also deduct that interest. Note that this deduction can apply to home purchases, home equity loans, or lines of credit.
There are state, local, and property taxes that can be deducted from your taxable income. You can claim such tax deductions on the property taxes you pay for your homes. But you can only do so if you owned the property and used it for personal use. If you’re looking for more property tax reductions, hiring property tax advisors like the JM Tax Advocates might be a great idea.
Routine Maintenance Costs
As an investor, you can deduct the expenses for routine maintenance costs during the year they occur. But the IRS defines routine maintenance as something that keeps your property in normal working condition. Thus, it only includes repairs or maintenance that does not add value to the property or prolong its useful life.
These are just some of the deductions you can utilize when investing in real estate. You can add up more deductions to lower your taxes. That’s why you must itemize deductions carefully. But also remember that you cannot use these itemized deductions if you opt for the standard deduction.
Use 20% Pass-Through Deduction
The Tax Cuts and Jobs Act of 2017 allows taxpayers like real estate investors who gain qualified business income (QBI) to use a pass-through deduction. It means that you can deduct an additional 20% of your real estate investing business income from your taxable income.
For instance, you own and manage a rental property with a net income of $40,000. You can potentially reduce $8,000, or 20% of the net income from the pass-through deductions on your personal taxes. But you might have to know other considerations, and it’s better to consult with a qualified tax professional to see if you would qualify.
Real estate is one of the best investment strategies to protect and grow one’s wealth. But like other investments, the amount you’re paying for taxes might affect your returns. The key is to be proactive about planning your taxes and understanding the tax advantages available in real estate investing.
Lauren Cordell is an expert in tackling issues about finance. It is her passion to help readers how to find the right investing strategy for them. She believes that making the right investment decision is a critical step to achieve financial freedom.