Learn the most common tax benefits of real estate and how they can be applied to your rental property business.
Real estate is the investment that "keeps on giving," and Andrew Carnegie famously attributed it to having created 90% of the world's millionaires. Whether that number is true or not, real estate is widely regarded as one of the best investments a person can make.
Another reason that real estate is a great investment is that it comes with great tax benefits.
This is because real estate tax law is set up to incentivize investment — it's the government's way of encouraging private investors to build and maintain affordable housing.
In this article, we'll highlight a few of real estate's most common (and most lucrative) tax benefits, including examples of how they can be applied to your rental property business.
Real estate tax law is a complex topic, so we want to preface this list by recommending that you consult a tax professional if you have any questions about the benefits we feature below.
A rental property comes out of the box with a number of write-offs (i.e., expenses you can deduct from your taxes), such as:
These expenses make up most of the cost of owning and operating a rental property and, as such, can be leveraged to lower your taxable income.
Additionally, a rental property owner can write off expenses from the everyday operation of a real estate business — things like:
If you can keep detailed records of deductible expenses tied to owning and maintaining your real estate, you could save a lot of money come tax time. Learn more about real estate tax deductions.
Hint: Azibo helps property owners keep track of these expenses with built-in ledgers, tagging and categorization, and reporting features.
The Federal Insurance Contributions Act (FICA) tax is a payroll tax that funds Social Security and Medicare in the U.S. This tax is usually split between employer and employee in every paycheck.
Self-employed people, however, must pay both portions of the FICA tax on any earned income. If you have a semi-successful business, this could equate to tens of thousands in extra taxes over the years!
Luckily, rental income isn't technically "earned income" and, thus, is safe from FICA tax.
Real estate assets (e.g., houses, apartment buildings, and even parking lots) all experience some form of regular wear and tear over the years that costs money to repair and maintain. Those repairs are business expenses that can be written off to reduce taxable income and, in some cases, tax liability. This income tax deduction is called depreciation.
Here's an example of how depreciation works:
Sara owns a duplex valued at $300,000. Over time, Sara's duplex will experience natural wear and tear (missing roofing shingles, deteriorating vinyl siding, etc.). Sara will eventually make repairs to her duplex and incur a business expense in materials and labor costs. The IRS recognizes this and allows her to deduct a set amount each year to recover these costs, all thanks to depreciation.
How to calculate your depreciation deduction
We only need two numbers to get a rough idea of how much you can deduct each year with depreciation.
Let's use Sara's duplex to find our first number.
According to the IRS, a residential property like Sara's is expected to last an average of 27.5 years, and this "expected life" is called a recovery period.
The second number, cost basis, is a bit harder to find, but can often be found by looking at your property tax assessment and then separating the value of the land from the structure itself. Why separate the two? Because land doesn't depreciate. Let’s say Sara’s property overall is valued at $500,000, but the land is valued at $200,000 — making her duplex’s cost basis $300,000.
Once you have those two numbers, you can calculate depreciation like this:
(Cost basis) divided by (recovery period) equals (depreciation deduction)
So for Sara, that would be:
($300,000) / (27.5) = $10,909 yearly deduction
This equation will give you an idea of how much you can deduct each year thanks to depreciation. As always, consult a tax professional to get an accurate depreciation calculation and avoid any errors that could put you at odds with the IRS.
Remember when we said the federal government incentivizes real estate investing? The tax benefits we'll share next are the most potent manifestation of those incentives — they are 1031 Exchanges and Opportunity Zones.
What is a 1031 Exchange?
A 1031 exchange allows a rental property owner to sell a property and reinvest the proceeds from that sale in another property of like-kind to avoid paying capital gains tax.
This is a major incentive that allows real estate investors to "trade up" for better properties and keep their tax burden down.
What are Opportunity Zones?
An Opportunity Zone is a designation the federal government gives to distressed, historically underserved areas in need of investments in infrastructure and affordable housing.
Real estate investors can invest eligible gains in these communities to defer, or sometimes eliminate, taxes they might otherwise owe from the sale of an asset.
You can find more information about Opportunity Zone investments on the IRS' official website.
Note that tax laws evolve, and incentive programs like 1031 Exchanges and Opportunity Zones may be limited or even repealed depending on the administration. Be sure to consult with your CPA before making investment decisions based on these incentive programs.
The Tax Cuts and Jobs Act (TCJA) established a new pass-through tax deduction in 2018 that businesses can use to deduct nearly 20% of their net income from income taxes.
This deduction is a potential game changer for real estate investors operating as a business (which you should be doing anyway).
Let's say you earn $100,000 in rental income each year. If you qualify for the pass-through deduction, only $80,000 of that income would be taxable at the end of the year.
There are a few criteria you have to meet to be eligible:
These are the baseline requirements — the boxes that MUST be checked. But, as always, speak with your tax advisor to find exactly what your business needs to qualify.
The government might incentivize owning real estate, but that doesn't mean they like collecting fewer taxes — you'll have to earn those deductions!
Here are a few things you can do to set yourself up to maximize your tax savings.
The best tax benefits go to businesses, not individuals, so take the time to set up an LLC, even if you're operating solo. Filing an LLC takes only a few minutes online, is relatively inexpensive (depending on your state) and provides other protections for landlords and their personal assets.
If you're building an all-star team for your business, a tax professional (especially one knowledgeable about real estate tax law) should be your first pick. Even if you typically file your own taxes, a real estate CPA will be sure to help you maximize tax deductions and keep you out of the IRS' crosshairs.
Good bookkeeping is crucial for all businesses, not just real estate investment companies. The extra effort will help qualify your business for tax deductions and incentive programs, and ensure you have an accurate record of business transactions. Consider using software like Azibo to track and organize your rental business finances online, for free.
Landlords who purchase and rent real estate may be intricately aware of their tax obligations, but may not always have the time or expertise to navigate an increasingly complex regulatory landscape. By educating yourself on the available tax benefits for landlords, you’ll be able to maximize your real estate profits each year.
Cody Rudolph is a real estate investor and digital marketing expert who writes about real estate investing, marketing, finances, software, and more at CodyRudolph.com.
Disclaimer: The information provided in this post does not, and is not intended to, constitute tax advice; instead, all information, content, and materials are for general informational purposes only. This content may not constitute the most up-to-date tax information. No reader, user, or browser of this article should act or refrain from acting on the basis of information herein without first seeking the advice of a tax professional.