It’s not how much you make; it’s how much you keep. Many of us have heard this saying before. As you may expect after reading the title of this article, this saying relates to the largest expense of your life: taxes.
If you have read any of my past writings or ever talked to me for more than five minutes, you’ll find that legally avoiding taxes is something I am passionate about. If there is one thing you can know for sure from me, it’s that I am not government-sponsored in any way, and you will not see any Business Insider-type propaganda about “why taxes are good” from me.
That aside, let’s look into some legal tax efficiencies from the greatest tax-saving investment vehicle, real estate.
Btw, although I may be smarter than many, I am not a licensed CPA or attorney, and you should always consult with your licensed professional on these topics.
Depreciation
Depreciation is a tax deduction that allows property owners to account for the decrease in value of an asset over time. For real estate, it recognizes that buildings wear out, become obsolete, or lose value due to various factors.
- Residential properties are typically depreciated over 27.5 years, meaning you can deduct about 3.636% of the property’s value (excluding land) each year.
- Commercial properties are depreciated over 39 years, allowing for an annual deduction of about 2.564%.
- This depreciation deduction reduces your taxable income, significantly lowering your tax bill each year.
Key Reminders with Depreciation
- Exclusions: Land is not depreciable; only the building and improvements are eligible.
- Recapture Tax: When you sell a property, the IRS requires you to pay taxes on the depreciation deductions you've taken. This is called depreciation recapture and is taxed at a maximum rate of 25%.
Cost Segregation Studies
Cost segregation is the process of identifying and classifying the various components of a property into different categories with shorter depreciation lives, allowing investors to accelerate depreciation deductions and reduce taxable income.
How Cost Segregation Works
- Property Classification: Divides costs into categories like:
- Real Property: Depreciated over standard periods (27.5 years for residential, 39 years for commercial).
- Personal Property: Items like furniture and fixtures, depreciated over shorter lives (5, 7, or 15 years).
- Land Improvements: Includes parking lots, landscaping, and fencing, often depreciated over 15 years.
- Professional Study: Conducted by a qualified engineer or tax professional.
- Tax Deductions: Enables larger deductions in the early years of ownership, improving cash flow and reducing tax liabilities.
Deductions for Expenses
In addition to depreciation, deductible expenses include mortgage interest, property taxes, insurance, maintenance expenses, and management fees.
1031 Exchange
A 1031 exchange allows investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar (like-kind) property, enabling portfolio growth without an immediate tax burden.
Key Points:
- Like-Kind Property: Properties must be used for investment or business purposes.
- Timeline: 45-day identification period and 180-day exchange period.
- Qualified Intermediary (QI): Must be used to execute a 1031 exchange, with no direct control over funds.
- Tax Deferral: Capital gains are deferred, not eliminated.
Home Office Deduction
The home office deduction allows you to deduct certain expenses related to the part of your home exclusively used for business purposes.
- Requirements: Must be used only for your real estate business and regularly.
- Methods for Deduction:
- Simplified Method: Deduct $5 per square foot, up to 300 square feet.
- Regular Method: Calculate actual expenses associated with the home office, like utilities, repairs, and depreciation.
Capital Gains Tax Rates
Capital gains tax is a tax on the profit realized from the sale of an asset, like real estate. The rate depends on how long the property is held.
- Short-Term Capital Gains: Assets held for one year or less, taxed as ordinary income.
- Long-Term Capital Gains: Assets held for over one year, taxed at reduced rates.
Qualified Business Income Deduction (QBI)
The QBI deduction allows eligible taxpayers to deduct up to 20% of qualified business income from a pass-through entity.
- Eligibility: Generally, rental real estate qualifies if over 250 hours per year are spent on rental activities.
- Deduction Amount: Generally 20% of QBI, with limitations based on taxable income levels.
Qualified Opportunity Zones
Opportunity Zones offer tax benefits for investing in designated economically distressed areas, aiming to spur development.
- Designation: Typically located in distressed areas, certified by the U.S. Treasury.
- Tax Incentives:
- Deferral of Capital Gains: Invest capital gains within 180 days to defer tax.
- Reduction of Capital Gains Tax: Hold investments for 5–10 years to reduce or exclude taxes on new gains.
As a wrap, there are numerous ways real estate investors can take advantage of tax deductions and savings. Remember to hire licensed professionals for legal, tax, and bookkeeping services. Our Limited Partners benefit from the tax savings we implement through our fund, demonstrating how real estate remains the leading asset class for investor tax savings.
Next, we’ll discuss income-based appraisals and how they differ from traditional residential property appraisals.
Stay gold,
Harrison & Alex
