Passive investing is a great form of investing for those looking to create consistent cash flow on a monthly basis. Just as appealing as the monthly cash flow provided by passive investing, though, are the tax benefits. Especially true with passive investments such as real estate, the government provides fantastic tax incentives for passive investors.
When investing in areas such as the stock market, investors are hit with capital gains taxes of 15% at the minimum. For those investors who bought and sold the stock within the same year, the tax rate could be as high as 37% – over one-third of the profit.
While technically landlords are subject to these same tax rates, real estate investing provides further tax incentives to help reduce these types of taxes. These same tax incentives are part of what make passive real estate investing a great option for any investor.
Here are some of the best tax benefits of passive investing:
Depreciation
Chances are, you’ve heard of depreciation as it relates to taxes. What you may not know is that depreciation is one of the great tax benefits when it comes to passive investing in real estate.
When investing in the stock market, the investor does not physically own any stock. There is no tangible item that can depreciate in value, meaning it cannot be written off. However, in real estate, the exact opposite is true.
The IRS allows you to deduct any business items with a shelf-life from your taxable income. When it comes to real estate, landlords generally have a great deal of “business items” that depreciate in value – including the property itself.
Understandably, the building itself along with other parts of the property will deteriorate over time if not maintained. The IRS knows this and allows this to be used as a tax benefit for real estate investors.
The lifespan of a property varies depending on the property type. For commercial real estate, the lifespan as determined by the IRS is 39 years. For residential property, the lifespan is classified as 27.5 years.
This is a great incentive for passive investors – especially those in residential real estate. Suppose your residential property is valued at $1,000,000. Because the IRS classified the lifespan of residential property at 27.5 years, this is the number you will divide the property by to determine depreciation.
In the above example, $1,000,000 divided by 27.5 years equals roughly $36,363. This is the amount you would be able to deduct from the income of the property each year.
Essentially, this allows the investor to show lesser profits from the property each year, thereby reducing the amount owed in taxes.
Section 1031
Section 1031 is one of the great incentives to real estate investing for those who plan to be invested for long-term gains. In simple terms, a 1031 exchange is the swapping of one property for another property.
The difference with a normal swap of property is that the investor sells their property and uses that money to buy another one, where they are then taxed for capital gains. The same is not true for a Section 1031 exchange, where the investor essentially swaps their property tax-free by the IRS.
There are many specifics to this rule, but many passive investors have taken advantage of it to drastically lower the amount of capital gains taxes paid. Instead of being taxed for the sale of every property, even if it is to purchase another one, the IRS only taxes the investor at the cash sale of the “final” property.
When the investor decides to get rid of a property and not swap it for another one is truly the only time they are taxed if they took advantage of Section 1031.
A Section 1031 exchange may be difficult to come by, though, because it is technically a swap from one landlord to another. However, you can use a middleman – known as a Qualified Intermediary – who holds the cash and then purchases another property with it.
Then, the investor never physically received the cash from the sale, meaning it falls in line with the rules of Section 1031.
Rental Income
Cash flow from passive real estate comes from rental income, which is taxed. However, unlike many other forms of revenue for investors, rental income has its own tax benefits.
One of the great tax benefits of rental income is that it is not subject to self-employment or FICA taxes.
The IRS taxes self-employed people at a base rate of 15.3% since they are not paying FICA taxes through an employer. This means that self-employed people owe 15.3% of their income at the end of the year to the IRS.
Luckily, the IRS does not classify rental income as income subject to social security or Medicare taxes, which is a great tax benefit. This is yet another area where it pays to be a passive investor, as you’ll inevitably owe far less in taxes in comparison to more active investing.
These Are Among Only a Few Benefits…
Passive investing provides a number of other tax benefits – but these are some of the most useful.
Depreciation of value, the ability to swap properties to avoid capital gains taxes and avoiding self-employment taxes on rental income are some of the greatest tax benefits when it comes to passive real estate investing.
Further reading on real-estate tax benefits and general knowledge can be found here.