I’m certain you have heard that there are many incredible tax advantages for the people that own real estate investments, and there are. The reason is the government wants you to own property, and so they reward you for it. Our nation’s tax laws are written to support the people who provide housing and invest into the community. Why do they want you to own property? Development and providing rental housing is something that is vital to the country and the economy, but it’s also a job the government can not do effectively. So they reward those who do with tax advantages. There are several tax advantages of owning rental property that compound the returns you will make. It makes investing in real estate even more lucrative than it already can be.
THE MAGIC OF DEPRECIATION
One of the biggest tax advantage provided to you for owning rental property is depreciation expense. Depreciation is magical! It’s a phantom loss, a paper expense you get write it in. It lowers your taxable income even though it does not actually lower your revenue. Everything but the land gets to be depreciated down to zero. That means that if the land is worth twenty thousand dollars and the building is worth eighty thousand, you get to write off the full eighty thousand of the building value over time against the income you make.
Currently buildings are depreciated over a 27.5-year life span. This means over that time you can deduct the full $80,000 from your income. It happens in equal installments and in this case that would be just over $2,900 a year. That’s $2,900 worth of income that you don’t have to pay any taxes on, just for owning the property. At the end of the year if you have $4,000 of income and profit for the property, you get to subtract $2,900 of your taxes. You only have to report and pay taxes on $1,100 of the income. You still made $4,000, but only have to report $1,100!! It’s magical!! If you pay over 30% in taxes, this means you would have around one thousand extra dollars in your pocket every year. An extra $1,000 in your pocket just for writing in the phantom expense of depreciation. Segregating the depreciation can make it even more powerful. Different systems and parts of the building have shorter or longer depreciation lives.
LOW TAX RATES
Another big one is simply the tax rate you are charged. Rental properties are considered passive income sources. As such are not subject to the personal employment taxes of social security and Medicare taxes. If you are self-employed that is a 15.3% tax savings. If you are an employee that is a savings of 7.65% compared to your W-2 income. Thanks to depreciation not only is your taxable income basis lower than your actual income, the income that is left to report is taxed at a lower rate!
Even when selling your property you pay a much lower tax rate. If you have owned it for more than one year your profit is only subject to long-term capital gains taxes. The long-term capital gains tax rate is typically a flat 15% for most people. If you buy and sell a property in less than a year though any profit will be subject to your standard tax rate and all self-employment taxes. I rarely sell anything. But it’s nice to know that if I do, I won’t lose a huge chunk of it to taxes!
GETTING TAXED ZERO WHEN SELLING
There is a way to get taxed ZERO on the capital gains when selling a property. That is through another tax advantage called a 1031 Exchange. There are too many rules to fully outline it in this article. The jest of it is that if you roll all the proceeds from the sale of one property into another property, the tax is deferred. Utilizing the 1031 Exchange can be an incredibly powerful way to move up the property ladder. You can continue to do this from property to property. It is a method many savvy investors have used as a catalyst to scale quickly.
Those are the big tax advantages, but there are so many others and write offs available. I recommend having a professional accountant file your annual reports and prepare your returns. Find one that is well versed in tax laws as they relate to rental properties, especially since the rules and laws can change year to year. You want to make sure you are taking every possible advantage available and not leaving money on the table. A good accountant can easily save you more in taxes than they charge you in fees. It is possible to have positive cash flow from your rental properties and pay zero in taxes for the year!