7 Top Tax Benefits Of Real Estate Investing

Investing in real estate has been widely known by the rich as a great way to build wealth because it gives investors a chance to:

• make passive income (cash flow)
• diversify their portfolios
• take advantage of market growth

However, one of the often-overlooked advantages of buying property is the signficant tax benefits of real estate investing.

In this article, we will discuss the 7 top tax benefits of investing in real estate. We’ll also look at how these can make a difference in your overall financial plan.

Disclaimer: I am not a tax professional only a periodontist! Make sure that you consult your CPA or tax professional before making any decisions or additional investments.

Join the Passive Investors Circle

#1. Lower Capital Gains Taxes

A capital gain is when you sell an asset at a higher price than what you initially paid for it.

The formula for calculating a capital gain is:

Selling Price – Purchase Price = Captial Gain

The government wants a portion of your income and taxes you on the profits generated from your investments. They want your money anyway they can get it. And this tax imposed on the profits from your investments are known as capital gains tax.

As per information on IRS.gov, nearly everything you own and utilize for personal or investment purposes qualifies as capital assets.

Examples of capital assets include:

• Your primary residence
• Personal-use items, such as household furnishings
• Stocks or bonds held for investment purposes

When you sell an asset for a price higher than your adjusted basis, you experience a capital gain. Conversely, you incur capital losses if you sell the asset for a price lower than your adjusted basis.

It’s worth noting that losses resulting from the sale of personal-use property, like your home or car, are not tax-deductible. Essentially, the government takes a share when you profit and offers no relief when you suffer losses. Good stuff, right?

Basically, a capital gain tax is a tax levied on the profits realized when an investor sells their assets for more than the original purchase price.

Your total income and how long you’ve held those assets determines how much you pay. There are two types to be aware of that impact your tax situation differently:

• short-term capital gains tax
• long-term capital gains tax

Short-term capital gains

A short-term capital gain occurs when you make a profit from selling an asset after owning it for less than a year. Although you might find yourself in a situation where selling is unavoidable, it’s crucial to understand that doing so could adversely impact your tax obligations.

This is because the gain is treated as ordinary income.

Long-term capital gains

If you profit from the sale of an asset held for more than a year, you’ll pay a long-term capital gains tax.

By doing this, you’ll keep more money versus holding it for less than a year as this tax has a significantly lower tax rate than your standard income.

If your income is low enough, you may not have to pay the tax at all. The long-term capital gains tax rates are 0, 15 and 20%, depending on your income.

Here are the brackets and percentages based on the 2023 tax law:

• $0 to $89,250: 0% capital gains tax
• $89,250 to $553,850: 15% capital gains tax
• Over $553,850: 20% capital gains tax

#2. Depreciation

Depreciation is possibly the biggest tax break regarding real estate investing.  This benefit allows real estate professionals to write off the property over time due to wear, tear, and deterioration.

Each year, investors can use depreciation deduction from pre-tax income to recover the cost basis of property over the years they own it.

Three types of depreciation

Straight-line depreciation

Residential rental property owners can depreciate their property over 27.5 years.

For example, the annual depreciation expense of a single-family rental home with a value of $300,000 would be ($300,000/27.5 = $10,909.09).

Accelerated depreciation

Property owners can hire an engineering group to perform a cost segregation study. 

This study “segregates” out the different building components, which can then be depreciated over shorter time schedules of 5, 7, and 15 years.

This is accomplished by identifying the non-structural elements plus any land improvements.

Examples include:

• appliances
• flooring
• cabinets
• parking lots

Investors receive more of an upfront depreciation benefit as accelerated depreciation creates large paper losses in the early years of ownership.

Bonus depreciation

The third type of depreciation method is bonus depreciation which allows a taxpayer to front-load the depreciation even more.

By utilizing this, investors can immediately depreciate items with less than a 20-year life in the first year.

---

---

#3. 1031 Exchange

As a real estate investor, you can use a tool in the tax code called 1031 like-kind exchanges which allows you to defer profits (capital gains) made on the sale of your investment property.

The catch is that another like-kind property must be purchased with the profit gained from the first property following a specific timeline.

The following rules apply to the use of 1031 exchanges:

• Exchange (sell) one property for another (like-kind). It must be real estate for real estate.
• The replacement property must be of equal or greater value.
• You have 45 days after you sell your property to identify up to 3 new properties.
• You’ve got 180 days to close on one or more of the three identified properties.
• Must use an intermediary to help which means that all the funds need to go through a neutral party.
• After agreeing on a sales price, the intermediary must wire the capital gains to the title holder.

As a side note, the Tax Cuts and Jobs Act (TCJA) made changes to 1031 exchanges stating they can only be used for investment or commercial property and can no longer be used for personal use.

#4. Tax Benefits of Refinancing

Depending on your finances and the terms of your new loan, refinancing your mortgage can give you a number of tax breaks. Some of the tax advantages of refinancing include:

Mortgage interest deduction: The interest you pay on a new loan after refinancing remains tax-deductible, just as it was with your original mortgage. This means you can still claim the mortgage interest deduction on your federal income tax return, which could lower your taxable income and overall tax liability.

Points deduction: You might be eligible to claim a tax deduction for points (sometimes referred to as loan origination fees or discount points) you pay while refinancing. Points are deductible during the course of the loan since they are treated as prepaid interest. You may occasionally be able to deduct all of the points you paid in the year you refinance, provided you meet certain requirements.

Home equity loan interest deduction: If you refinance and get a home equity loan or line of credit to make improvements to your home, the interest on this new debt may also be tax-deductible. The Tax Cuts and Jobs Act (TCJA) limited this deduction to home equity loans that were used to buy, build, or significantly improve the property that secured the loan. The total of your first mortgage and home equity loan can’t be more than $750,000 if you’re married and filing jointly, or $375,000 if you’re single or married and filing separately.

Remember that tax laws are constantly changing. Make sure that you check with your tax professional or financial advisor to ensure you understand the potential tax implications and benefits.

#5. Opportunity Zones Investing

The fifth tax benefit of real estate investing is investing in a qualified opportunity zone (QOZ).

The Tax Cuts and Jobs Act created this program which encourages real estate investors to put their money in low-income areas in the United States by offering significant tax benefits.

Capital gain tax on a property sale can be deferred by investing in a QOZ through qualified opportunity funds (QOF). The deferral is in effect until the investment is sold or exchanged or on Dec. 31, 2026, whichever comes first.

Like the 1031 exchange timeline, the QOZ investment program must also meet certain requirements.

Within 180 days of the sale of the real property, the capital gains must be invested and needs to be exchanged for equity interest and not debt interest.

The time period in which the investment is held determines the amount of tax benefit received. 

In addition, if you hold an investment in a QOZ fund for at least five years, you’ll receive a 10% capital gains tax reduction. If you hold for at least seven years, you’ll receive a 15% reduction.

Once you hit the 10 year mark, the basis can be adjusted to its fair market value on the date it’s sold or exchanged.

#6. The 20% Pass-Through Deduction

Another benefit the Tax Cuts and Jobs Act created was a pass-through qualified business income deduction. According to IRS.gov, this allows eligible self-employed and small-business owners to deduct up to 20% of their qualified business income (QBI), plus up to 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income on their taxes.

Business owners that are sole proprietors, LLCs, and S-Corps with taxable income less than $170,050 ($340,100 if married filing jointly) will be able to deduct 20% of their qualified business income.

For example, if you have a business with net operating income of $100,000 and W-2 wages of $100,000, you can deduct $20,000 from your net operating income ($100,000 x 20%).

If you’re over the income limit, complicated IRS rules determine whether your business income qualifies for a full or partial deduction. Check with your CPA for help with this and other tax issues. 

#7. The Short Term Rental Tax Loophole

This loophole can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity”.

From The Real Estate CPA site, here are the six ways in which income for a rental property can be excluded from the definition of rental activity, and thus not automatically passive:

1. The average period of customer use for such property is seven days or less.
2. The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers. This could include services like a hotel would provide, such as daily cleaning or meals.
3. Extraordinary personal services (same as above) are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use). 
4. The rental of such property is treated as incidental to a non-rental activity of the taxpayer.
5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.
6. The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity.

Steps to take to shelter income

Let’s break this down in laymen’s terms for you:

• Buy a short-term rental
• Materially participate
• Obtain a cost segregation study
• Use accelerated depreciation the first year
• Claim paper losses from your business
• Hire a real estate CPA who understands how to use the tax deductions from your short-term rental and apply it to your ordinary income 

Join the Passive Investors Circle

Bottom Line

By understanding and taking advantage of these 7 tax benefits, you can save money and grow wealth more efficiently.