Investing in real estate can be a great way to create residual wealth and generate passive income. Indeed, one of the reasons so many people are drawn to this asset class is because of its tax benefits. In addition to generating positive cash flow and realizing appreciation, commercial property can be used to help offset a person’s other taxable income.
In this article, we explore some of the tax strategies real estate investors can use to maximize their returns.
Maximize Interest Deductions.
Most people use some form of leverage to buy commercial property. They’ll pay anywhere from 2.5 to 8% or more in interest on these loans. As a general rule, people can deduct interest on money they borrow for a business or investment activity, including being a landlord. Therefore, all mortgage interest payments can be deducted on the owner’s tax returns (using Schedule E and by classifying this as a “business expense”). The mortgage interest deduction reduces a person’s taxable income by the amount paid in mortgage interest over the course of the year.
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Each individual owner can take this deduction on a loan of up to $750,000. Borrowers who took out a mortgage loan before December 2017 can deduct the interest on principal up to $1 million.
Eligible interest deductions include: mortgage interest payments used to acquire the rental property; mortgage interest payments used to improve a rental property; interest on credit cards used for goods or services related to the rental property; and interest on personal loans used to purchase or improve rental property.
Capture Other Deductions for Rental Property.
While mortgage interest payments are arguably one of the largest tax write-offs investors can take, there are others. Additional deductions include property taxes, depreciation, and repair and maintenance costs.
Operating costs like as property management fees, insurance, taxes, utilities, and marketing fees are also considered eligible write-offs. The costs associated with capital improvements cannot be written off. Those have to be depreciated, which we’ll discuss in more detail below.
Maximize the Grandaddy of All Deductions – the Depreciation Deduction.
Perhaps the single most significant tax break for real estate investors is the depreciation deduction. The IRS allows owners to deduct “a reasonable allowance for exhaustion or wear and tear, including a reasonable allowance for obsolescence.” Even if a property is technically appreciating in value, owners can take this depreciation expense.
Historically, people had two options: they could use “straight line” depreciation or “accelerated” depreciation. With straight line depreciation, multifamily owners could depreciate their properties equally over a 27-year period. Commercial properties, like office buildings and retail centers, were depreciated over a 39-year period. This is what the IRS considers the “useful life” of these property types.
With accelerated depreciation, an owner can hire someone to do a “cost segregation study” which assigns a specific life to each individual building component. For example, doors and windows are given a lifespan vs. flooring vs. roofing vs. landscaping. In doing so, an owner can take more depreciation sooner than they could with straight-line depreciation—hence, accelerated depreciation.
However, in recent years, the IRS has allowed property owners to take what’s known as “bonus” depreciation. Bonus depreciation allows an investor to deduct the full cost of capital improvements in the same tax year the expense is incurred. This applies to all properties acquired and placed in service after September 2017.
Depending on the value of the property, bonus depreciation can generate tens (or hundreds) of thousands of dollars in tax savings. This is a one-time tax break. After someone takes the deprecation, they can no longer take depreciation on that property again. Many investors would rather the big, one-time lump sum savings which they can then turn around and invest in another property.
For some investors, the value of bonus depreciation far outweighs any cash flow they anticipate receiving from a rental property. In turn, some investors will buy a property with slim margins simply to take the depreciation benefits.
It’s also why you’ll see some investors buy another property every year or two. They use their bonus depreciation savings to invest in another property, then use bonus depreciation on that property to roll into another property, etc. They do this again and again while growing their real estate portfolio.
Utilize Capital Gains Tax Breaks When Selling Real Estate.
Whenever you sell an investment property, the capital gains tax will apply. However, the tax rate you pay on your profits depends on the holding period and other factors – so it pays to be aware of these rules. For investments held for one year or less, a higher short-term capital gains rate applies. But if you hold onto them for more than a year before selling, then the lower, long-term capital gains rate applies. It’s always good to monitor the tax implications associated with when you sell a property. By leveraging the long-term capital gains tax rate, you’ll pay less in taxes and put more money back into your pocket.
Consider Deferring Capital Gains Tax Entirely with 1031 Exchanges.
Of course, some real estate investors have learned that instead of paying capital gains tax, they can grow their portfolios using 1031 exchanges. Section 1031 of the Internal Revenue Code stipulates that people can defer paying capital gains taxes on investment property, as long as the capital gain is rolled into another “like-kind” asset of higher value.
Let’s say someone was planning to sell a property for $1 million with a $250,000 gain. Depending on a person’s tax bracket, they could pay upwards of 20% in taxes on that gain. So, instead of taking home $250,000, they’ll be taking home $200,000 (or less, when you account for broker fees, legal fees, and other transaction costs).
Instead, someone can roll that $250,000 gain into the purchase of another property. In doing so, they can defer paying capital gains taxes.
Note: you do not eliminate paying capital gains taxes. You’ll eventually have to pay those taxes upon the sale of the property.
There are also several guidelines you must follow to qualify for a 1031 exchange. Most people utilize what’s known as a “Deferred Exchange”. With a Deferred Exchange, a person has 45-days from the sale of their property to identify the replacement property (or properties). Then, within 180 days of the sale of their property, they must acquire that property. If you don’t follow these rules precisely, the entire gain could be subject to taxes.
Many real estate investors will use 1031 exchanges time and time again to grow their real estate empires.
Pass Real Estate on to Heirs at a Stepped Up Basis.
As we mentioned above, a 1031 exchange only defers having to pay capital gains taxes. The IRS assumes you’ll eventually pay out on the capital gains upon the sale of the property.
Of course, there’s a loophole here that many investors use. Some investors will use 1031 exchanges in perpetuity to expand their real estate holdings. They’ll put that property into a trust for their heirs, and then their heirs will inherit that property at what’s known as a “stepped up basis”. When the taxpayer dies, the built-in gains virtually disappear and the full value of the property “resets” with the new owner.
Let’s see what that might look like in practice.
Assume that Investor Pete has amassed a real estate portfolio worth $20 million. Over the years, he’s used 1031 exchange to grow his portfolio. Therefore, he has yet to pay capital gains taxes. He has about $8 million in gains that would otherwise be taxable upon the sale of his portfolio.
Investor Pete is also in the highest tax bracket. He’d be paying an estimated $1.6 million in capital gains taxes if he were to sell his portfolio during retirement. Instead, he hangs on to that property and puts it in a trust for his daughters. When Investor Pete passes away, his daughters take title to his real estate portfolio. They decide to sell the property for $20 million, but at this time, they do not owe capital gains taxes since they received the property at the stepped up basis.
This is a staggering $1.6 million in capital gain tax savings that Investor Pete was able to pass on to his daughters, thereby promoting intergenerational wealth.
Monitor Other Potential Tax Incentives.
In addition to the standard real estate tax incentives outlined above, there are other tax incentives that pop up from time to time. For example, the federal Tax Cuts and Jobs Act of 2017 established the “Opportunity Zone” program. Investors who buy, improve, and hold property in designated Opportunity Zone districts are eligible for significant tax breaks.
Another example is tax incentives provided through the Inflation Reduction Act (IRA), first introduced in the summer of 2022. The IRA provides several direct cash rebates and other tax write-offs for investors willing to make certain energy-saving improvements at their rental properties. For example, the IRA provides over $9,000 in savings and a 30% tax credit to install solar panels. It also offers up to $14,000 in rebates to purchase heat pumps and energy efficient appliances. Over a multi-unit property, these incentives can really add up and bolster an investor’s returns.
There are countless ways for people to passively invest, but commercial real estate offers unique tax benefits that are not available when investing in other asset classes. For these reasons, people should strongly consider adding real estate to their investment portfolio.
Of course, the tax benefits associated with any specific deal will vary depending upon a person’s individual circumstances. We always recommend consulting with your tax advisor to see how these benefits apply to you.