According to experts, real estate is – and continues to be – one of the most popular investment strategies for building wealth. A large part of that has to do with the extensive tax incentives that allow you to not only lower your annual tax bill, but take advantage of many opportunities that you can’t find elsewhere.
The trick, and the challenge, is first knowing what tax benefits exist in real estate, and second, knowing how to use the available strategies to lower your tax obligations. Here’s a rundown of the top tax benefits of real estate investing.
Real estate deductions
One of the best tax benefits of real estate investing is the ability to claim deductions. These are tax write-offs, mostly geared towards rental properties, that allow you to claim numerous expenses related to the maintenance, mortgage costs, and operating expenses of an investment property.
When you purchase real estate as an investment with the goal of making a profit, the IRS sees that as a business transaction. Therefore, any costs that come with this purchase are seen as legitimate business expenses that are tax deductible. These include:
- Mortgage interest: The interest portion of your monthly mortgage payment is tax deductible.
- Property taxes: These can be written off as a cost of owning the property.
- Property insurance: Like property taxes, property insurance is a tax write-off for investment properties.
- Ongoing property maintenance/repairs: Any money that you spend to repair damages or maintain the property can be deducted. If you’re upgrading a property, however, that is not a tax write-off.
- Contractors/equipment: Contractors or equipment hired for maintenance or repair.
- Property management fees: If you hire a property management company, that is considered a tax-deductible expense.
If you’re investing in real estate through limited liability partnerships or limited liability companies, you can also use the following real estate business deductions available to business owners to lower your tax bill:
- Office space
- Business equipment
- Travel and mileage
- Advertising expenses
- Legal and accounting fees
Passive income and pass-through deductions
In real estate investing, passive income is classified as money that’s earned through a business activity that investors don’t physically participate in. The most common form of passive income in real estate is rental income from an investment property. Until 2018, this income has not been eligible for pass-through tax benefits, but the Tax Cuts and Jobs Act of 2017 changed that.
The Tax Cuts and Jobs Act enables businesses that earn qualified business income (QBI), which includes rental income, to pass up to 20 percent of their taxable income with a pass-through deduction, thus reducing the effective income tax rate by 20 percent. This benefit is only available until 2025 and you can only take advantage of this deduction if your business was profitable in your tax reporting year.
Real estate investment trusts (REITs), which is how all our investments at Arrived are set up, qualify for passthrough taxation.
Capital gains are the profit you make when you sell a property for more than you bought it. This includes all properties, including residential properties, commercial properties, and rental investments. Capital gains taxes are generally lower than the equivalent tax on your ordinary income, which is what makes capital gains a particularly good tax benefit for property owners investing in real estate. Capital gains are taxed in one of two ways:
Short-term capital gains
These are capital gains that are received from investment properties that were held for less than a year. There is no real tax benefit for short-term capital gains, which is treated as ordinary income, and therefore, the regular IRS-defined tax bracket will apply.
Long-term capital gains
Long-term capital gains are gains made on properties that were held for more than a year. Long-term capital gains are taxed at 0%, 15%, or 20%, depending on your income band, which is a significantly lower rate than that applied to regular income. The low tax on long-term capital gains is part of what can make real estate investing for the long-term extremely profitable.
Depreciation is the incremental loss of a property’s value due to wear and tear. The IRS allows for an annual depreciation deduction on income-generating properties based on how much the property is worth, the recovery period of the property, and the depreciation method used.
The most common method used for calculating depreciation is called the Modified Accelerated Cost Recovery System (MACRS), which allows you to deduct depreciation on an income-producing residential property for 27.5 years (the “useful life” of a property) and commercial real estate for 39 years.
On an investment property, depreciation is classified as a net loss, even if the real estate investment is producing positive cash flow. What makes the depreciation deduction so valuable to real estate investors is that you can claim it even if you didn’t spend any money on this expense. And if you do spend money on repairs, maintenance and upkeep, that is considered a separate, additional expense. This is not a deduction available to homeowners who live on the property.
Also important to remember: while the “useful life” of a property is considered to be 27.5 years for tax purposes, properties last far longer, thus allowing investors to get disproportionate benefit in the early years of an investment.
Real estate investors can use the internal revenue code called 1031 Exchange to defer the taxes on a property if the profit from the sale is used to buy a new one.
As a real estate investor, when you sell a property for profit, you are required to pay taxes on the capital gains from that property. What the 1031 Exchange tax code does is allow you to forego paying taxes on this income for as long as that money continues being invested in more real estate.
A few things to remember about 1031 Exchanges:
- The replacement property must be of equal or greater value than that of the property sold.
- You must identify the new property you plan to buy within 45 days and close on that property within 180 days.
- The property transactions must be similar in nature. For instance, a property cannot be exchanged for other types of assets, such as Real Estate Investment Trusts (REIT).
- The exchanged properties should be used for “productive purpose in business,” that is, as an investment, and not as a residential property.
Under the Tax Cuts and Jobs Act (TCJA) of 2017, opportunity zones were created as an economic development tool to help growth in some of the country’s most distressed and disadvantaged areas. The IRS lists 8,764 opportunity zones across all 50 US states and investors can get significant tax breaks by investing in these regions.
Any capital gains earned from selling an investment property can be put into an opportunity zone fund, allowing investors to defer or pay no capital gains tax on the original investment.
The tax benefits of investing in an opportunity zone include:
- Temporarily defer taxes: You don’t owe any capital gains until 2026, or until the asset is sold.
- Grow capital gains by 10%: If you place capital gains in an opportunity fund for at least 5 years, the basis on the original investment will increase by 10%. After 7 years, the basis will increase to 15%.
- No capital gains: If you remain invested in the fund for 10 years or more, you can forego paying capital gains entirely and have it be tax-free profit.
Tax-deferred retirement accounts
You can use a health savings account (HSA) or SDIRA (Self-Directed IRA) to invest in real estate and defer your taxes. A Self-Directed Real Estate IRA is a retirement account that is similar to a traditional IRA but that can be used to invest in real estate. Any returns from this type of investment are tax-deferred and must be deposited back into the IRA.
The Federal Insurance Contributions Act (FICA) splits tax between the employer and employee. If you’re self-employed, you are responsible for the full 15.3% tax. This is known as the Self-Employment Tax. Currently, the US government does not look at rental real estate as a self-employed business, and so rental property income is not taxed as “earned income,” which means it is not subject to the FICA tax.
Tips for capitalizing on real estate tax benefits
Knowing the tax benefits of real estate investing is only a start. You have to understand how to take advantage of them to truly reap their rewards. Make sure that you’re making the most of the tax benefits and tax cuts available to you with the following tips.
- Keep detailed records: Make sure to keep all your receipts, organize your records, and have detailed information about what you spent on your property, like when you made repairs, the taxes you’ve paid, and one-time expenses such as the cost of listing it for rent or sale.
- Hire a CPA: Hiring a tax professional who knows what tax breaks you’d be eligible for, and who can put together detailed documentation, can save you both time and money. It’s also a good way to ensure you’re not leaving money on the table by missing out on some of the obvious tax benefits available to you. (This is also a tax-deductible expense.)
- File on time: Make sure to stay on top of IRS deadlines and tax returns by submitting all the required paperwork either by yourself or with the help of a professional.
How do taxes work with Arrived?
Investing in real estate through Arrived allows you to benefit from all the tax advantages mentioned above. Additionally, Arrived investments are structured as Real Estate Investment Trusts (REIT), giving you even more tax benefits that other types of real estate investments don’t get.
- We depreciate our homes over their useful life. This reduces taxable income by deferring taxes until the property is sold, which can be several years later.
- We’re able to use the Qualified Business Income deduction to reduce our income by 20%. This is a massive deduction that Arrived qualifies for by being a REIT.
- Instead of paying a corporate income tax, we distribute nearly all earnings directly to investors each year. This passthrough structure avoids the double taxation issue that comes up with corporations and their dividends.
- When the home is sold, the capital gains from the sale are taxed at lower rates than most other income.
What are your tax obligations?
Income from real estate, like all income, is subject to taxation. Arrived uses the tax rules described above, but investors will still need to pay some taxes on the income they receive.
Each January, we’ll send you a 1099-DIV form. This will detail the amount and type of income you received from your Arrived investments. The form will have all the information you need to file your taxes.
Start real estate investing with as little as $100
In addition to the cash flow and passive income, one of the biggest benefits of real estate investing is the tax benefits. Understanding what these tax strategies are and how to use them is key to reducing your tax liability and increasing your bottom line.
Investing with Arrived allows you to take advantage of all the benefits of real estate investing. You can check out our available properties here and start investing for as little as $100.