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"Because real estate is such a valuable asset, the government taxes it heavily"
When it comes to investing in real estate, taxes are among the most important criteria to consider as it constitutes a significant portion of the return-on-investment (ROI) calculation.
Because real estate is such a valuable asset, the government taxes it heavily. If you're not careful, your real estate investment could end up costing you more in taxes than it makes you in profits.
However, there are five ways to minimize your tax liability and help you save more money which we have outlined below:
1. Deduct a portion of the cost of the property as depreciation
If you own income-producing rental property, you can deduct a portion of the cost of the property each year as depreciation. This can help to offset any other income you may have from the property, and reduce your overall tax bill.
Various methods of depreciation are popular for accounting purposes in the real estate industry, with the two most popular being MACRS and cost-segregation. The Modified Accelerated Cost Recovery System (MACRS) approach allows residential rental properties and structural improvements to be depreciated over 27.5 years and 15 years for appliances and fixtures. Cost segregation is another approach which utilizes accelerated depreciation deductions by classifying certain interior and exterior components of a building–which are typically depreciated over 39 or 27.5 years for commercial and residential properties, respectfully–to personal property or land improvements that are depreciated over 5, 7, or 15 years. (We’ll do another posting on cost segregation as it deserves more discussion.)
This loss, together with other expenses like utilities and insurance, are reported on Schedule E, federal income tax Form 1040, and deducted from ordinary income.
2. Take Out A Loan Against Your Home Equity
If you have a sizable equity in your home, you can take out a loan against it and use the proceeds for anything you want. This can be a handy way to access cash without having to sell your property. Regulations will vary from state to state and the ability to borrow against your home equity will also depend on your credit score.
3. Apply for 1031 Exchanges
If you sell an investment property, you may be able to defer paying taxes on the sale by reinvesting the proceeds into another piece of investment property. This is done through a 1031 exchange in accordance with Section 1031 of the Internal Revenue Code. This can be a smart way to defer taxes while still growing your real estate portfolio.
To qualify for 1031 exchanges, the properties must meet the following requirements:
The aggregate value of replacement properties must equal or exceed the relinquished property when exchanging.
The assets being traded must be "like-kind" or also have to fall within similar types. In other words, real property cannot be traded in exchange for a real estate investment trust or REIT.
Both properties must be income-generating.
1031 Exchanges also deserve further discussion, so look for a future discussion on this topic.
4. Deduct Mortgage Interest Payments From Your Taxes
If you own a home, you can deduct the interest you pay on your mortgage from your taxes. This can help to reduce your overall tax bill each year.
To qualify for this, the IRS is instructing homeowners that they can "deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1 million or $500,000 if married filing separately)) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017." See the IRS Pub 936 for more information.
5. Defer Taxes on the Sale of a Home
If you're in the market to sell your primary residence, it's helpful to know that any gains from its sale may be tax-exempt. Married couples who file jointly can enjoy a capital gain tax exemption of up to $500,000 and $250,000 for single individuals. This is if the taxpayer has lived in the home for two of the last five years. Refer to this IRS tax tip for more information.
Indeed, real estate can be a lucrative investment, but it's critical to understand the tax implications. As a property owner, you are likely aware of the various expenses that come with maintaining your property, including your annual tax bill. While there may be no way to completely avoid paying taxes, learning these five ways of reducing your tax bills can help you make the most out of your property investments.