The importance of real estate investing and tax planning shouldn’t be overlooked. Did you know that if you use tax mitigation techniques like cost segregation, your real estate investments could reduce your tax bill to zero today?
In many cases, you can create a net operating loss in the present. Then, this loss can be carried into future tax years as well.
Tax Planning And Your Cash Flow
Whether you’re active or passive investing, one thing is certain: cash flow is king. Some people buy a property because they expect the value to appreciate significantly. They don’t care about cash flow because they just look for a quick return, so they sell after a few years for a tidy sum.
Other types of investors buy a property because it has the potential to generate consistent revenue each month. These are the ones that get to enjoy a passive income source that can fuel their retirement account or build enduring wealth over time.
Whether investors are seeking cash flow or appreciation, they often forget one important thing: Tax planning.
Unlike many other investment types, real estate investing is ideal for improving your cash flow and lowering your tax bill. Even if you primarily care about your property’s appreciation rate, you can still benefit financially by reducing your tax liability and enjoying a higher tax flow.
Most people fail to remember that the tax code was designed to spur economic activity and fund the government. If you run a business or have a rental property, there are portions of the tax code that were made to incentivize your company’s growth.
We can argue about whether the tax code achieves these goals, but the reality is that the result has been a range of tax deductions and credits for investors.
When you consider the tax rate of investors, you can see that they generally pay the least amount in taxes simply because they have access to tax deductions that other actors in the economy (like employees) don’t.
Investors pay a capital gains tax when they sell their investments. Depending on factors like how long they held the investment, the capital gains rate can be 0, 12, or 15 percent of their investment.
And if they do passive investing, investors do not have to pay a self-employment tax bill.
Ultimately, the tax code is designed to make people pay less if they contribute more to the economy. By spending money on an investment property or starting a new product line, business owners, self-employed individuals, and investors help to provide new jobs and sources of economic growth.
It’s important to note that they still have to pay a Social Security tax and Medicare tax if they hire employees. They also have to pay a sales tax on the majority of items they buy for their company. Anyone who buys rental properties has to pay a property tax each year.
This essentially means that investors help fund the government by creating opportunities for new tax payments. By giving these groups tax breaks, the government hopes to encourage other activities that will generate tax revenue.
How Can Investors Lower Their Tax Bills?
There are several tax benefits you can enjoy as a property owner and many factors that can help you lower how much you pay to the federal government if you do your tax planning right:
Deductions
Deducting mortgage interest is generally the largest deduction that taxpayers get, but it also applies to investors as well. If you own an investment property for passive income, you can take advantage of this deduction. Also, this deduction works for home equity loans, refinanced mortgages, and lines of credit.
To claim the mortgage interest deduction, you will need your Form 1098 from your mortgage lender. This form will show how much you paid in tax costs for the year as well as how much money you can deduct. The deduction also works for any payments or insurance premiums that went through an escrow account.
Property Improvements
While improvements help you boost your property’s value, repairs are designed to keep your property in working order. According to the tax code, you can write off your repairs right away. Because improvements add value over time, the value has to be depreciated over multiple years. The type of improvement determines how long it takes to depreciate the cost.
Business Expenses
If you are actively investing and managing your property, you should be able to deduct almost all of the expenses associated with running your business. For example, you can deduct the cost of your internet bill and phone bill. You may also be able to deduct your travel costs each time you go to view the property.
Tax Planning Using the 1031 Exchange
When you use a 1031 exchange, you can delay your tax bill until you sell your property. Instead of paying a tax bill, you can invest those funds in another property. A 1031 exchange lets you exchange your first property for another property without paying a capital gains tax on it.
To get this tax benefit, the new property must meet certain eligibility criteria. It must be a like-kind exchange. This means that if you originally sold a residential property, you should also be buying a residential property. with the same or greater value than your previous property.
By doing this, you can postpone your tax bill and you get to reinvest your profits into a new property. Because of this, you get to earn profits from your postponed taxes until you eventually sell the new property. As long as you never divest completely, you can keep using a 1031 exchange to postpone your capital gains tax.
Depreciation
As buildings age, they start to break down. The Internal Revenue Service (IRS) calls this process depreciation. To accommodate for wear and tear, the IRS lets investors depreciate the value of their assets over time. This allows you to reduce your overall tax liability.
You can depreciate the value of residential property over 27.5 years. For commercial properties, you can extend depreciation over 39 years.
Assuming that you have a residential property worth $400,000, you can depreciate 85 percent of the property’s value. Because land is 15% of the property’s overall value, you cannot depreciate the last 15%. Land does not deteriorate in the same way that buildings do, so the value theoretically remains the same.
For the next 27.5 years, you will be able to depreciate 85 percent of your original investment. This works out to $340,000 in total. Each year, you can depreciate $12,363.60. Even if you exclude other tax breaks, this works out to a hefty tax reduction. If your property normally brings in $1,000 a month in rental income, the depreciation creates a net operating loss.
On paper, you are effectively losing money each year. In reality, you are bringing in $1,000 a month and will eventually profit through the sale of the building as well.
Passive Income and Real Estate Investing Can Lower Your Tax Bill
When you invest in real estate, you get to use a range of different tax deductions and credits. By using these tax benefits, you can end up saving a significant amount of money each year. To realize these savings, you just have to do some tax planning in advance. With the right planning, you can use your tax savings to fund your passive investing in the future.