Investors buy and own investment property because it has the potential to generate long-term wealth, generate cash flow, and provide a profit when the asset is sold. However, these investments come with their own set of issues, one of which is taxation.
Taxes can have an impact on your investments both during the holding term and after the sale. The cash flow and revenue generated by owning an investment property are taxed as ordinary income. Profits from the sale of real estate are also taxed at the federal capital gains rate, as well as at the state level in some cases.
There are, however, ways to design a tax strategy that would allow you to keep more of your money.
Taking advantage of tax incentives and deferments provided by the tax code can help you keep more of your money working for you, allowing you to better plan for the future. By continuing to chase passive income streams and cash flows while simultaneously employing smart tax methods to help control or, in some cases, avoid taxes entirely, investors can strive to keep more of their primary investment.
You can defer or minimize your tax burden on your investment properties in a variety of ways, and you’ll need to figure out which option is best for you based on your present assets and income demands. The following are some of the most successful tax reduction options for investors.
Take Advantage of Investment Property Deductions
Taking advantage of as many deductions on your investment properties as feasible is one of the best strategies to keep more of your money working for you. Here are a few examples of tax deductions:
- Interest on a mortgage
- Maintenance, advertising, and property management fees are all costs associated with renting a home.
- Homeowners’ insurance
- Costs of closing and related legal fees
- Any real estate investing-related tools, home office expenditures, or trip expenses
Everyone’s tax situation is different, and you may be eligible for additional deductions that are tailored to your needs. Because tax regulations change frequently and can be confusing, it’s advisable to seek advice from an accountant to determine which deductions to take.
Consider hiring an accountant that specializes in investment properties, as they may be familiar with tax deductions and tactics that you wouldn’t discover on your own. Your accountant can assist you in keeping track of these expenses throughout the year to ensure you don’t miss out on any tax breaks.
Depreciation by Leverage
Another strategy to reduce your tax burden is to take advantage of depreciation on your properties. Each year, the IRS permits you to deduct depreciation on your properties from your taxes.
This deduction is valid for the whole life of your building, as defined by the IRS. A residential building’s lifespan is now established at 27.5 years, whereas a commercial building’s duration is fixed at 39 years, according to the IRS.
In the case of a residential property, this implies you can deduct 1/27.5 of the property’s value from your taxes each year, or around 3.6 percent. This can save you a lot of money; for instance, if your building is worth $100,000, you can deduct $3,636 off your taxes each year.
It’s crucial to remember that depreciation applies to a wide range of assets, and the IRS is fairly lenient when it comes to enabling investors to take advantage of this deduction. This deduction can also be used to make capital upgrades to your home in many circumstances. Let’s pretend you spent $5,000 on a new furnace for your home. For the life of the furnace, you can deduct an additional $180 every year (3.6 percent of $5,000).
You should also bear in mind that if you sell a property and have taken depreciation deductions, the IRS will levy you depreciation recapture taxes. As a result, if you plan to sell your investment property soon, speak with a tax professional.
Cost Basis is Increasing
Another option is to increase the cost basis of your property. When implemented appropriately, this method can be hazardous, but it can also be incredibly effective.
The acquisition price of the property is your initial cost basis. By borrowing money for capital improvement projects, borrowing against the home for another purchase, or refinancing your mortgage, you can increase your cost basis with this technique.
From a tax standpoint, there are a few ways that increasing your cost basis can help you. In the short run, you’ll save more with your yearly depreciation deduction. You will also be able to save money on capital gains taxes in the long run.
Consider the following scenario: you paid $450,000 for a home. You spend $75,000 on upgrades while you hold the property, bringing the cost base up to $525,000. You sell the property for $600,000 a few years later. In this situation, you only have to pay taxes on a $75,000 profit rather than $150,000, which is a huge tax reduction.
With a 1031 Exchange, you can postpone paying taxes.
You can delay capital gains taxes on the sale of your investment property if you exchange it for like-kind property of greater or equal value via a 1031 exchange. When it comes to performing a 1031 exchange, there are certain timing regulations and ramifications to bear in mind, so make sure you can meet the identification and exchange dates and that you’re selling the property for a replacement investment of greater or equal value.
It is not about how much money you make, but how much money you keep. You can potentially reduce the amount you pay in taxes for your investment properties each year by employing these tax reduction tactics, allowing your hard-earned money to work harder for you.
David Wieland is the author.
Realized, a real estate wealth tech organization that provides Investment Property Wealth Management® to investors is founded and led by David Wieland.
I’m being completely honest. This website does not provide investment, tax, or financial advice. For counsel on your individual circumstance, you should seek the opinion of a licensed professional.