Taking full advantage of tax breaks is one of the best ways to maximize your rental income.
What most landlords don’t know is that there are quite a number of tax benefits that come with investing in real estate.
Unfortunately, filing taxes for rental properties is not optional. And sometimes it can be very expensive.
But, that’s only if you don’t know how to use tax benefits to your advantage. Real estate tax breaks can actually save you thousands of dollars every year.
So, if you are looking for ways to maximize your rental income by minimizing your tax expenses, you are in the right place.
This post explains how four of the best tax benefits can help your bottom line.
Four of the Best Tax Benefits for Real Estate Investors
Of course there are more than four tax breaks available for real estate investors. That’s why it’s wise to familiarize yourself with each one, keeping in mind where your investment is located, and its surrounding legislation.
It could mean the difference between paying or saving thousands of dollars in tax. Here are four of the best tax breaks to start you off on your money saving journey:
1. Depreciation Benefits
You read that right – properties do depreciate with time. Now, it may seem a bit confusing given that property values often go up with every year that passes.
So, it’s only natural to ask: How does depreciation work?
Generally, investment properties are considered assets by the IRS. That means that in the eyes of the government, your investment property loses its value over time.
And that’s why they often allow property owners to deduct a depreciation expense from their total rental income.
Amazing, right? Well, it gets better.
According to the IRS, a rental property’s useful or productive lifetime is 27.5 years and 39 years for commercial properties.
Basically, this means that you can deduct a depreciation expense from your annual rental income for 27.5 years.
The expense is meant to cover your property’s “exhaustion” or “wear and tear” over time.
And while property exhaustion is rarely the case – thanks to preventative measures and proper maintenance – nothing much changes.
So, how can you calculate your property’s depreciation expense? It’s simple.
Use this formula:
Annual Depreciation Expense = Total Value of Property/Number of Productive Years (in this case, 27.5)
Therefore, if you own a $200,000 rental property, your depreciation expense will be:
Annual Depreciation Expense = $200,000 / 27.5 = $7,273
Basically, that means that the IRS will allow you to deduct $7,273 from your gross annual rental income each year. It’s a massive save, isn’t it?
To calculate depreciation, you have to factor in three things:
- Your property’s value
- A depreciation calculation method
- Your property’s recovery period
In most cases, the Modified Accelerated Cost Recovery System (MACRS) depreciation method is often applied. It helps you to calculate home much taxes you’ll owe after making a depreciation deduction.
For example:
If your property is worth $200,000 and yields around $30,000 a year in rent. Here’s how to calculate your taxes.
The tax amount you owe without a depreciation deduction = $30,000 * 25% (federal income tax) = $7,500
On the other hand…
The tax amount you owe with a depreciation deduction = ($30,000 – $7,273) * 25% (federal income tax) = $5,682
Therefore, a depreciation deduction on a $200,000 property cuts down your tax expenses by $1,818 ($7,500 – $5,682) every year.
Additionally, the more properties you own, the bigger the tax saving.
2. Other Tax Deductions
Apart from depreciation deductions, there are other expenses you can write-off from your gross rental income.
What are these expenses?
Generally, all expenses incurred to manage, preserve, and maintain a property can be written off from the total taxable income.
These expenses include:
- Property management expenses
- Insurance premiums and Mortgage interests
- Utilities, repairs and maintenance expenses
- Marketing and tenant screening costs
The main reason why these expenses are deductibles is that they do not add value to the property.
Instead, they are incurred to preserve and maintain the property.
3. The 1031 Exchange
If you think you’ve seen the best of tax benefits, then you are wrong.
The 1031 Exchange is just as awesome as the ones above. So, what is it?
The 1031 Exchange gets its name from Section 1031 of the Internal Revenue Code. This tax benefit allows property investors to swap properties without having to pay their normal sales tax rates.
Basically, during a swap, you can pay little or no tax at all to get the new rental property.
Tthis tax break allows you to transfer your capital gains from the old to the new property.
Think of it as a sale; only this time you get paid in form of another property instead of cash.
Unfortunately, as good as it may sound, there are a few conditions that must be met; including:
- The new property must be used for productive business purposes.
- Both properties must be considered “like kind.”
- The new property should be equal or great in value to the old property.
4. Capital Gains Tax Benefits
Capital gains are the profits you make from selling a piece of property.
Now, there are two main types of capital gains. They are short-term and long-term gains.
The difference between the two is that only one of them offers you tax benefits.
So, which one is it?
You’ve probably been told to hold your property for more than a year before putting it back on the market. Short-term gains come from the sale of a property owned for less than a year.
This is bad because it comes with no tax benefits. So, you’ll be expected to pay the taxes at the usual rates.
However, long-term gains are beneficial in that you get to pay taxes at lower rates. But that’s only if you own the property for more than a year.
Also, your tax obligations reduce as time goes by.
The longer you own the property, the lower your tax burden will be when you decide to sell.
In summary, taking advantage of all available tax breaks can be a great way to cut down your tax burden.
The benefits above will give you a great start towards saving thousands of dollars in taxes each year.