Real Estate Investing & Taxes - What you need to know
Investing in real estate is a lucrative way to build long-term wealth and generate passive income. Investing in Real Estate offers several different benefits. A common one that other investors talk about is the “tax advantages”…but what does that even mean? Unless you’re a CPA or know tax law, it’s hard to grasp what type of tax benefits one really sees by investing in Real Estate, or on the other hand, the tax dis-advantages. However, understanding the tax rules and regulations that apply to real estate investing is essential to making informed decisions and maximizing your profits.
Let me take you through the advantages and disadvantages of real estate investing as it relates to taxes. Now, let’s not forget, I’m no CPA and this is definitely not tax advice. I have a great CPA I’d be happy to refer to you if you want professional advice on the subject!
TAX advantages
depreciation
Depreciation is a tax deduction that allows investors to deduct a portion of the cost of their rental property each year. This deduction can significantly reduce the amount of taxable rental income, which can lower your overall tax liability.
For Example: You purchase a rental property for $300,000. The IRS allows a depreciation deduction of 27.5 years for residential rental properties. Therefore, you can deduct $10,909 ($300,000 divided by 27.5 years) each year for depreciation. So, although the property itself is likely appreciating in value, you get to deduct depreciation since the property is likely to see more wear and tear as a rental property vs. a homestead property.
1031 EXCHANGES
A 1031 exchange is a tax-deferred exchange that allows investors to defer paying capital gains tax when they sell one investment property and purchase another. This tax benefit can help investors save money on taxes and reinvest more of their profits into new properties.
For example: You sell a rental property for $500,000 that you purchased for $300,000, netting you $200,000 in profit. You would owe capital gains tax that profit (this tax is based on your annual household income but can range from 10-25%). However, if you choose to reinvest the $200,000 proceeds into a "like-kind" property within a certain timeframe, you can defer paying the capital gains tax until you sell the new property. This tax benefit can help you save money on taxes and reinvest more of their profits into new properties. There is a funny saying in the investing world…”defer, defer, defer, die”…you get the picture.
PASSIVE ACTIVITY LOSSES
Real estate investors who actively participate in the management of their rental properties can deduct up to $25,000 in losses each year against their other income, such as their salary or business income. This can be particularly beneficial for investors who have high levels of income from other sources.
For example: Let’s say you own a rental property that generates a net loss of $30,000 a year. You can deduct up to $25,000 of that against your other income, therefore, you don’t pay taxes on $25,000 of your other income. Let me point out that ideally you never own a rental property that loses you $30,000 a year, but some investors actually use this as a strategy to minimize their taxable income.
TAX disadvantages
Unfortunately, there are some disadvantages that can come with Real Estate investing. Although in my opinion, the advantages outweigh the disadvantages. Either way it’s important to know both sides of the coin.
Rental Income Taxation
As with any income, rental income is subject to federal and state income taxes. The amount of tax owed on rental income depends on the investor's marginal tax rate, which is determined by your total income. This can result in a significant tax burden for investors with high levels of rental income. That being said, there are ways to minimize the income tax issue, like using the depreciation deduction mentioned above and can you say, hello, write offs?! A CPA or professional in the industry can help your strategize on how to minimize the hit on income tax.
Capital Gains Tax
When an investor sells a property for more than they paid for it, they will owe capital gains tax on the difference between the purchase price and the sale price. The amount of capital gains tax owed depends on the investor's marginal tax rate and the length of time they owned the property. This can result in a significant tax liability for investors who sell properties that have appreciated in value. One way around this is to use a 1031 exchange previously mentioned, and defer any capital gains taxes on an investment by purchasing another investment property.
Complexity
Overall, tax rules and regulations can be complex and vary based on the investor's specific situation. This can make it challenging for investors to understand their tax obligations and take advantage of all available tax benefits. If you are involved in Real Estate Investing or are in the process of building a portfolio, I would advise you to seek the guidance of a tax professional to navigate these complexities.
While there are significant tax benefits to investing in real estate, there are also potential tax liabilities that you must consider. Understanding the tax rules and regulations that apply to real estate investing is essential for making informed decisions and maximizing profits. If you do it right, there is a lot of money to be made in Real Estate!
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