Who doesn’t love paying less in taxes? Taxes are by far the largest expense we have in our lifetime, so why not find every possible way to reduce how much you pay legally? Investing in real estate can bring several tax advantages and incentives to legally lower your tax bracket. We discuss some of them here.
How do taxes work?
Many countries, including the United States, operate a progressive tax system -- meaning the amount an individual is taxed increases progressively as their net income increases. The IRS uses a marginal tax rate to calculate your taxes, based on your taxable income. This is your adjusted gross income minus any qualified business expenses or deductions.
There are some standard deductions for those whose main earnings come from a job. But the IRS also rewards producers in our economy, so there are specific tax incentives and deductions for those who own a business, physical real estate, or commodities. By taking advantage of these deductions, credits, and laws, you can potentially lower your tax bracket and decrease the amount of taxes you have to pay.
Change the type of income you earn
There are three different classifications of income in the eyes of the IRS: earned income, investment income, and passive income. The type of income determines how you are taxed. One of the easiest ways to reduce your tax bracket is by changing how you earn your money. Earned income -- also known as ordinary income -- is taxed at a higher rate than that of investment income, and is income you’d receive from a regular W-2 job, or if you’re self-employed.
In real estate, the most common form of investment income is the profit made from selling a property for more than the price it was purchased for, which is called capital gains. Capital gains are taxed based on the period of time for which the investment is held. Short-term capital gains are used for any asset held for less than a year, and are taxed at a rate similar to that of earned income (i.e., anywhere from 10% to 37%). However, if the property is held for at least a year and a day, the profit is taxed at a long-term capital gains tax rate, which is significantly lower (i.e., anywhere from 0%, 15%, or 20%). For this reason, holding properties for at least a year before selling them is favorable when trying to realize the best tax rate.
Passive income in real estate is income that is earned through residual cash-flowing properties such as a rental, REIT dividend, crowdfunding income, or private-equity income. Passive income is taxed at a rate similar to that of earned income, but there are deductions available to lower the net taxable income made from the real estate investment. The largest of these is called a pass-through entity, which we will discuss in more detail later.
By changing the income you earn from ordinary income to investment income or passive income through real estate, you can lower your overall tax bracket.
Invest in properties with an S corp or LLC
If you plan on actively investing in real estate -- meaning you want to put in the time and effort to find, acquire, and manage your real estate investments -- there are tax advantages to creating and conducting business through a limited liability company (LLC) or limited partnership (LP).
What matters is how you invest in real estate through an LLC. Rentals or properties held for longer periods are taxed differently than properties that are bought and sold quickly -- which the IRS could perceive as being a “dealer.” If the IRS considers you a dealer, you may be subject to paying double the FICA taxes. FICA taxes cover social security and medicare and are typically taxed at 6.2%, but when you are self-employed or classified as a dealer, you may have to pay FICA taxes twice, as both the employee and employer.
There are ways to avoid this by structuring an LLC so it is also an S corp. However, it’s best to consult a qualified and experienced accountant that is familiar with real estate investing to help you better determine which entity and structuring would be best for you.
The benefits of LLCs go beyond tax incentives. They are commonly used in real estate because they can potentially lower liability, and if set up correctly can offer a certain level of protection in the event of litigation. Oftentimes, real estate professionals will have several different pass-through entities primarily for tax and asset protection purposes.
Utilize the 20% pass-through deduction
The Tax Cuts and Jobs Act (TCJA) of 2017 created a new deduction for businesses that operate as a pass-through entity, such as an LLC, S corp, or limited partnership. The pass-through deduction, also known as section 199A, allows taxpayers who earn less than $157,500 for single filers or $315,000 for joint filers to deduct 20% of their qualified business income (QBI) that they receive through their pass-through business.
This allows some small business owners or self-employed individuals to pass the business deduction to their personal tax return. This lowers the business’ taxes while deducting up to 20% of the net income from their personal taxes. While this deduction is not exclusive to real estate, it does apply to anyone who buys and owns real estate with a pass through entity. For example, a landlord owns and manages several rental properties in an LLC which made a net income of $30,000 after expenses and deductions. The landlord can potentially pass $6,000, or 20% of the net income from the pass through entity as a deduction on their personal taxes.
The pass-through deduction does not apply to corporations, employee income, or service professionals such as dentists or doctors. But it is available to those who earn income through:
- Rental property and spend at least 250 hours a year or more managing the rental
- Origination or investment in mortgage notes and spend at least 250 hours managing the asset
- Dividend payments from shares in a REIT
The 20% pass-through deduction can be an incredible tool for individuals who invest in real estate to reduce their tax bracket. If you think you could benefit from this tax incentive, speak with a local and qualified tax professional about your business to see if you would qualify.
Take advantage of real estate business deductions
One of the easiest ways to lower your tax bracket through real estate is by taking advantage of deductions available to business owners. There are several deductions specific to business owners and real estate investors, such as:
- Property taxes and insurance paid on an investment property (which cannot be deducted on a personal residence)
- Mortgage interest (which can be deducted for both a personal residence and an investment property)
- Property management fees
- Property repairs, including capital improvements
- Advertising expenses
- Legal and professional fees (such as an accountant or bookkeeper)
- Office expenses, including a home office
- Travel and mileage expenses
- Education and memberships (such as the annual fee for a trade association or cost for a seminar, book, or course on a topic relating to your industry)
- Meals (entertainment such as taking a client or private lender to a baseball game, is no longer deductible under the TCJA)
Utilizing these deductions when investing in real estate can potentially add up to a notable decrease in your tax bracket.
Deduct passive losses
Although no one buys a real estate investment with the intention of losing money, real estate investment does carry risk, and losses in real estate are not uncommon. Additionally, what may be positive cash-flowing assets can appear as a loss on your tax return after depreciation and tax deductions have been applied.
Passive investments such as rental properties may generate passive losses. Passive losses can only offset passive income -- so you can only write off as much loss as you have in passive income. For example, if you make less than $100,000 per year and three of your six rental properties showed a passive loss of $10,000, you can only write off the $10,000 if you also have $10,000 or more in passive income from your other three rentals. If you do not reach $10,000 in passive income from the other three then you cannot deduct the full $10,000 that you incurred in losses.
With the rental loss allowance, if your adjusted gross income (AGI) is less than $100,000, you may be able to deduct up to $25,000 in passive losses across all rentals.
Situations where the investor does not have enough passive income to offset the passive loss are fairly common and the losses can be carried forward to future tax years. However, those who meet the requirements of real estate professionals can treat passive income losses as active. So let's have a look at how you can qualify as a real estate professional.
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Gain a real estate professional designation
A real estate professional designation offers a substantial tax break that can significantly reduce your taxes. With this designation, you can deduct up to 100% of your rental losses against any other type of income, including ordinary income. If you have $10,000 in passive losses, you no longer need $10,000 in passive income to offset this. You can deduct the entire $10,000 against any other income, including other real estate income or possibly self-employed income.
To qualify, you must dedicate a minimum of 750 hours per year to your real estate business and actively participate. At least 50% or more of your time needs to be spent actively working on the rental, including management or services performed for it. Actively participating can include meeting with contractors, tenants, on-site managers, or attorneys, in addition to reviewing or creating contracts, leases, marketing campaigns, or offering memorandums.
The goal is to have most of the work you do be in an active role rather than a more passive one, such as reviewing your bookkeeping, financials, or learning more about your business. Keep in mind -- the 750 hours is the minimum threshold to qualify. If you’re audited and the IRS disqualifies a few hours, you could lose the designation and any deductions that were received from that designation. It’s ideal to have around 900 hours or more dedicated to that business, as well as proven records showing your active role in at least one half of the services or management performed for each investment property.
Although there are advantageous tax incentives to being designated a real estate professional in the eyes of the IRS, it does require active management, the dedication of a significant amount of time, and you need to qualify. If your goal when investing in real estate is to do so as passively as possible, this designation and its tax incentives will likely not be an option.
Depreciate your properties
Depreciation is a deduction available to property owners that allows them to take a small deduction each year to account for the average wear and tear on an asset over time. Residential properties can be depreciated over a period of 27.5 years. Commercial properties can be depreciated over a period of 39. If you purchased a residential rental property for $200,000 you would be able to depreciate or deduct $7,272 each year on your taxes ($200,000/27.5).
Although depreciation offers a deduction in taxes now, the deduction is regained upon the sale of the property. So when you sell the property, any depreciation taken to that point would be recouped. However, there are tax-deferral strategies such as a 1031 exchange, which can potentially avoid or delay the recapture of depreciation.
Bonus depreciation and cost segregation
Cost segregation is the process of identifying the different property components for depreciation purposes. Rather than depreciating the entire asset at the same time, cost segregation depreciates different aspects of the property over different periods of time.
For example, you can cost-segregate the land the property is on, as well as the building itself and any construction or capital improvements that were made to the property. Cost segregation can increase the depreciation amount because of the accelerated period of time in which you can depreciate certain parts of the asset.
Bonus depreciation is a temporary change to our tax law that allows taxpayers to potentially deduct up to 100% of certain qualifying assets that are associated with a qualified investment property. This means investors can now accelerate the time in which items like a new roof, light fixtures, interior paint, new flooring, or appliances can be depreciated from five, seven, or 15 years, to potentially 100% in the first year.
For example, if a new roof was installed on a commercial property that cost $35,000 this entire cost can be depreciated in the year it was completed, rather than having to depreciate it over a period of five to seven years. That turns a $5,000 depreciation deduction per tax year into a one time $35,000 deduction.
According to the IRS, improvements do not qualify if they are attributable to:
- The enlargement of the building
- Any elevator or escalator
- The internal structural framework of the building
With Section 179 of the tax law, commercial real estate can now write off the installation of an HVAC, fire protection systems, alarm systems, and security systems, as well as landscaping. In the past, you could not write these off because they are part of the building. But the new tax laws mean that you now can.
To qualify for bonus depreciation, the property must have been acquired after September 27, 2017, and before January 1, 2023, and the bonus depreciation must be taken in the year the qualifying property was purchased. Keep in mind: When taking advantage of bonus depreciation, the asset will have fewer depreciation deductions in the following year. The tax law rewards those who continue to invest, so it is ideal to continue to buy new properties each year in order to take advantage of the bonus depreciation tax deduction.
Find an experienced accountant to help you
Be proactive about planning your taxes. What you do on a day-to-day basis affects how you earn income, how much tax you pay, and how quickly your financial goals are achieved. Most people consult their accountant after they’ve made a big decision, which may affect their tax bracket.
Instead of taking an “as needed” approach to tax planning, learn about the tax law and what behaviors, investments, and spending habits the tax law rewards. That way you can make more informed decisions as you invest in real estate. Tax laws change, and it’s important to have a quality accountant who can help you navigate the various deductions that are available and hopefully assist in lowering your tax bracket through your real estate investments.