By David Wieland
Investors acquire and own investment property because it can be a potential way to create long-term wealth, generate cash flow for investors, and create a profitable return when the asset is sold. However, these investments have their own set of challenges, one of which may be taxes.
Taxes can impact your investments both while you own the property and after you sell it. Cash flow and income from the ownership of investment properties are taxed as regular income. Additionally, profits from the sale of real estate are taxed at the federal capital gains rate and sometimes also at the state level.
However, there are ways to create a tax strategy that can help you keep more of your money in your pocket.
Taking advantage of tax incentives and deferments available in the tax code can allow more of your investment to work for you, allowing you to better plan for your future. Using the principles of wealth management, investors can try to retain more of their primary investment by continuing to seek income streams and passive cash flows while using sophisticated tax strategies to help manage or, in some cases, defer taxes altogether.
There are many ways to defer or reduce your tax burden on your investment properties, and you’ll need to find the right strategy for you based on your current investments and income needs. Here are some of the most effective tax reduction strategies for investment property owners.
Leveraged deductions on your investment properties
One of the best ways to grow more of your investment is to take advantage of as many deductions on your investment properties as possible. Here are some of the tax deductions available:
- Mortgage interest
- Rental expenses, including maintenance, advertising and property management costs
- Home Insurance
- Closing costs and associated legal costs
- Any tools, home office expenses, or travel expenses related to real estate investing
Everyone’s tax situation is unique, and there may be other deductions you can take that are specific to your needs. Since tax codes change frequently and can be very complex, it is best to consult an accountant to help you determine which deductions to use.
Consider working with an accountant who has special knowledge of investment properties, as they may have knowledge of deductions and tax strategies that you wouldn’t find on your own. Your accountant can help you track these expenses throughout the year to make sure you don’t miss any deduction opportunities.
Another way to potentially reduce your tax burden is to take advantage of depreciation on your properties. The IRS allows you to deduct depreciation on your properties as part of your taxes each year.
You can use this deduction for the life of your building as defined by the IRS. The IRS currently sets the life of a residential building at 27.5 years and the life of a commercial building at 39 years.
For a residential property, this means you can deduct 1/27.5 of the value of the property each year as part of your taxes, which works out to around 3.6%. This can lead to significant savings – for example, if your building is valued at $100,000, you can deduct $3,636 from your taxes each year.
It is important to note that depreciation applies to many types of property and the IRS is generous enough to allow investors to use this deduction. In many cases, you can also use this deduction to improve the fixed assets of your property. Let’s say you spend $5,000 on a new furnace for your property. You will be able to deduct an additional $180 per year (3.6% of $5,000) for the life of the furnace.
You will also want to keep in mind that the IRS charges depreciation recapture taxes if you sell the property and have taken depreciation deductions. For this reason, consult your tax advisor if you plan to sell your investment property in the near future.
Growing cost base
Another strategy to consider is to increase the base cost of your property. This strategy can be risky, but it can also be very effective when used correctly.
Your initial cost basis is the purchase price of the property. With this strategy, you would add to that cost base by borrowing money for capital improvement projects, borrowing against the property for another purchase, or refinancing your mortgage.
Increasing your base cost can benefit you in several ways from a tax perspective. First, you’ll save more through your annual short-term capital cost allowance. In the long run, you will also be able to save money on capital gains.
For example, suppose you originally purchased a property for $450,000. While you own the property, you make $75,000 of improvements, which raises the base cost to $525,000. A few years later, you sell the property for $600,000. In this case, you only have to pay tax on a profit of $75,000 instead of $150,000 – a significant tax saving.
Defer taxes with a 1031 exchange
With a 1031 exchange, you can defer capital gains taxes on the sale of your investment property if you exchange the property for a similar property of equal or greater value. There are specific timing rules and implications to keep in mind when it comes to performing a 1031 exchange, so it’s important to ensure you can meet the ID timeline and deadlines. exchange and you sell the property for an equal or greater replacement investment. assess.
It’s not about the money you earn, it’s about the money you keep. By using these tax reduction strategies, you can potentially minimize the amount you pay on your investment property taxes each year, allowing your hard-earned money to work harder for you.
About the Author: David Wieland
David Wieland is founder and CEO of Realized, a real estate technology company that provides Investment Property Wealth Management® to investors.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.