Real estate is a highly profitable form of investment, with the average rate of return for residential rentals at 10.6% and commercial rentals at 9.5% — one of the highest in investing.
But real estate investing also comes with many tax benefits as well.
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From deductions to tax-deferments, there are a number of ways to save. Still, if you’re considering entering the rental market and want to reside in your property, there are differences in being a landlord investor, owning a split residential/rental property, or renting out your vacation home to offset your costs. Here are the tax benefits of investing in real estate, including properties in which you reside.
Rental property deductions
There are a number of deductions you can claim if you are a landlord, whether you reside on the property or don’t.
If you have a mortgage on a rental property and pay loan interest, the interest is deductible. You may also deduct origination fees used to purchase your property, along with interest on unsecured loans and/or credit card interest on purchases and improvements related to your property.
As having insurance is a necessary expense for renting a property, it is considered deductible. This includes any liability insurance.
When you rent a property, the wear and tear that takes place over time depreciate the value of your property. If the rental is residential, your deduction is the cost of your property divided by 27.5 for the year of ownership. This means if you have purchased a rental property for $300,000, your depreciation deduction would be $10,908 annually.
The following expenses may also be deducted:
- Fees you pay to receive a mortgage, including recording fees, inspection fees, or mortgage commissions.
- Legal fees toward the mortgage or rental.
- Travel and transportation costs to manage your property.
- Advertising and expenses incurred to manage and rent your property.
- Repairs, improvements, restoration, and betterment of your property.
- Property tax.
- Rental licenses.
Deductions if you live on the property
The IRS states that if your rental expenses exceed your gross rental income, you cannot deduct them. Your gross rental income is the rental portion of mortgage interest, real estate taxes, casualty losses, realtors’ fees, and advertising costs.
If you rent a property that you live in for more than 15 days, such as a vacation home, or rent a portion of the property that you call home, you will have to adjust your deductions. For example, if you own a duplex and live in one unit and rent the other, the interest would be divided in half for personal and rental deductions.
You can only deduct depreciation on the portion of your property that is used for rentals. This means if you have purchased a rental property for $300,000 but occupy half of the property, your depreciation deduction would be $5,454 annually.
Your city, county, or state may also charge you occupancy taxes if you rent short-term. These are deductible as well.
If you own a partial interest
If you have invested in real estate with others and hold partial interest in a rental property, the IRS allows you to deduct the percentage of expenses that match the percentage of ownership. For example, if you co-own a property, you can deduct 50% of the expenses listed above.
Rental property is an investment and should you choose to sell your property, you can certainly make a profit. This is called a capital gain and you have to pay taxes on it. How you are taxed on this gain depends on how long you have owned the property: is it a long-term or a short-term gain?
If you sell the property under a year of having ownership, it will be considered a short-term gain and you will be taxed as if that capital gain is income.
If you sell after owning the property for more than a year, you could be taxed at 0%, 15%, or 20%, based on your income.
Selling your property also affects your depreciation in what is called a depreciation recapture. If you have received tax deductions based on your depreciation rate, the IRS will want that back and may tax you as high as 25% on it.
For example, if you purchased the property for $300,000 and claimed the $5,454 annual deduction for five years before selling, that is $27,270 that can now be taxed at up to 25%, equaling $6,817.50.
Capital gains if you live on the property
Once again, your capital gains and taxes will need to be divided and adjusted if you sell a property that was both your home and a rental. While homeowners who have lived on the property for a minimum of two years are exempt from capital gains if the profit is less than $250,000 (single) or $500,000 (married), the rental portion of a home and depreciation collected will be taxed.
A 1031 exchange allows you to sell a rental property and use the proceeds to purchase another investment property. This exchange will void taxes on capital gains as well as depreciation recapture if the new property value is equal or greater than the property you are selling. If you purchase a property with a lesser value, the balance will be considered a gain and will be taxed.
Tax-deferred retirement accounts
Investments you have may also help you defer taxes on your rental properties. A self-directed individual retirement arrangement (SDIRA), for example, allows you to invest in real estate.
Any income you make on the property goes back into the SDIRA and keeps your money protected from taxes. You can invest and purchase real estate through a traditional SDIRA, in which you pay taxes when you sell the property, but the winner is a Roth SDIRA, in which you pay the taxes when you invest in the property. (Paying taxes up front will most likely be cheaper than paying at the sale years down the line.) The only caveat is you can’t withdraw the gains before age 59.5.
Opportunity Zones (OZ) are properties in “economically distressed communities where new investment, under certain conditions, may be eligible for preferential tax treatment.”
If you sell a rental property and invest the capital gains into a qualified OZ fund within 180 days, you can delay capital gain taxes until selling your stake in the OZ or until December 31, 2026, when the program ends. The longer your money is invested in OZ, the bigger the reduction you’ll pay on your capital gains. Fund OZ for five years and save 10%.
If you live on the property
If your primary residence is your rental property, a 1031 exchange can be performed on the portion of the rental that was used as a rental. Vacation homes that have been rented for more than 14 days that you have not lived in for more than 14 days and that you have owned for more than two years qualify for the 1031, as well.
A Roth SDIRA cannot be used to purchase property for personal use so you cannot live on the property.
If you’re interested in investing in real estate – these companies are for you
Not only are the tax deductions a benefit to investing in real estate, being a landlord is called a passive activity because you earn income without providing a service. This income is taxed lower than your earned income from an employer. The income you earn from your rental property also gets sheltered by depreciation.
Let’s say your rental income is $15,000 for the year and your property depreciation rate is $8,000. Your depreciation would be deducted from your income and your taxable passive income would be $7,000.
If you’re interested in investing in real estate, a number of online platforms are making it easier than ever.
You can invest in single-family rentals through Roofstock, which provides an online marketplace for buyers and sellers of investment properties with whole or fractional ownership shares of fully managed properties. Users can search available properties, see current rent payments, neighborhood ratings, and review total return calculators for 5 to 30 years.
Fundrise is a crowdfunding platform allowing you to invest in commercial real estate through group investing. With just a minimum of $500 for the Starter level to $10,000 or more in the Advanced level, your funds will be diversified across 5 to 80 commercial developments, respectively.
Streitwise offers unaccredited investors the chance to join Real Estate Investment Trusts (REITs) trusts by charging up-front fee discounts for higher returns. Streitwise owns the commercial properties they are investing in, which means the company makes 100% of the profits and shares it with investors — the average return on investment is 9.8%.
Real estate investing can be highly lucrative if done properly. Using the 1031 exchange to continue to invest more and more over the years is just one of the tax advantages that support real estate investors.
Taking advantage of the many deductions and tax benefits will ensure the greatest potential for earning as you delve into the world of real estate investing.