You may have heard that diversifying your investment portfolio is good and that mixing in real estate investments can create valuable, recurring cash flow. But did you know those investments can be tricky come tax time?
What can you write off?
In addition to property taxes, mortgage interest, property management fees, and costs to maintain and repair buildings, you can also write off a lot of what you use to run the business, including:
- Advertising
- Office space
- Business equipment, e.g., computers, stationary, business cards, copiers, etc.)
- Legal and accounting fees
- Travel
A pass-through deduction is also an option that allows you to deduct up to 20 percent of your qualified business income (QBI) on your personal taxes. The money you collect in rent, as a sole proprietor, partnership, LLC, or S Corp, is considered QBI. The perk, however, is set to expire in 2025.
Opportunity zones are low-income or disadvantaged tracks of land investors put money into developing. It works when multiple investors place unrealized capital gains into a Qualified Opportunity Fund that goes toward improving the selected area. Opportunity zones have the following tax advantages:
- Defer paying capital gains until 2026 (or until you sell your stake in the fund).
- Grow your capital gains by 10 percent if you hold the fund for 5 years; 15 percent for 7 years.
- Avoid paying capital gains entirely if you remain invested in the fund for 10+ years.
Where it gets slippery.
The above may seem like good reasons to invest, but things get slippery when you want to depreciate costs over time.
Depreciation is the incremental loss of an asset’s value over time. On income-producing property, you can deduct depreciation as an expense on your taxes, lowering your taxable income and possibly reducing your tax liability. However, you may not claim depreciation on property held for personal purposes. Also, land is never depreciable, although buildings and certain land improvements may be.
You are allowed to take the depreciation deduction for the entire expected life of a property (currently set by the IRS as 27.5 years for residential properties and 39 years for commercial properties).
Example
You purchased a home you intend to rent out. The value of the building itself (excluding the land it sits on) is $300,000. If you divide that value by the 27.5 year expected life of the dwelling, you can deduct $10,909 in depreciation each year.
Once you sell, be prepared to pay the standard income tax rate on the depreciation you’ve claimed. That requirement is known as depreciation recapture, which you can avoid if you pursue other tax strategies, like a 1031 exchange.
Capital gains assessed when you sell an asset, can also impact your taxes differently depending on if it’s a short- or long-term gain.
When you profit from selling an asset within a year of owning it, you realize a short-term capital gain that may have a negative effect on your taxes. That’s because the gain gets counted as ordinary income. With long-term capital gains, you profit when you sell an asset that you’ve held for a year or longer.
Real estate investing has many tax advantages, but it can be tricky. Avoid making mistakes or missing out on deductions. Give us a call.
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