In our recent interview with Slocomb and Phil, we looked at the importance of real estate investing and tax planning. If you use tax mitigation techniques like cost segregation, your real estate investments could reduce your tax bill to zero today. In many cases, you can create a net operating loss in the present. Then, this loss can be carried into future tax years as well.
Tax Deductions Help You Boost Your Cash Flow
Whether you are actively investing or prefer passive investing, your cash flow is king. Sometimes, people buy a property because they expect the value to appreciate significantly. These investors do not care about cash flow because they just want to sell the property in a few years for a tidy sum.
In other regions, investors buy a property because it brings in a consistent revenue each month. Over time, they get to enjoy a passive income source that can fuel their retirement account or build intergenerational wealth. Whether investors are seeking cash flow or appreciation, they often forget one important thing.
With tax planning, you can immediately boost your cash flow. Even if you primarily care about your property’s appreciation rate, you can still benefit financially by reducing your tax liability and enjoying a higher tax flow. Unlike many other investment types, real estate investing is ideal for improving your cash flow and lowering your tax bill.
This is because the tax code was designed to spur economic activity and fund the government. While we can argue about whether the tax code achieves these goals, the result of these goals has been a range of tax deductions and credits for investors. If you run a business or have a rental property, there are portions of the tax code that were made to incentivize your company’s growth.
If you look at the different entities that make up the economy, they look like a quadrant. You have employees, self-employed individuals, business owners and investors. When you consider the tax rate of each quadrant, employees typically pay the highest rates. This is because employees do not have the same access to tax deductions that the other three groups get to use.
Out of the four groups, investors generally pay the least amount in taxes. Investors pay a capital gains tax when they sell their investments. Depending on factors like how long they held the investment, the capital gains rate can be 0, 12 or 15 percent of their investment.
Because they do passive investing, investors do not have to pay a self-employment tax bill. Normally, self-employed workers have to pay things like the Social Security tax and FICA tax. When employees work for a company, the business is responsible for paying half of these tax costs.
Ultimately, the tax code is designed to make people pay less if they contribute more to the economy. Business owners, self-employed individuals and investors are generally charged a lower tax rate because they fuel the economy. By spending money on an investment property or starting a new product line, these groups help to provide new jobs and sources of economic growth.
While these groups may pay a lower tax rate, they still have to pay a Social Security tax and Medicare tax if they hire employees. They also have to pay a sales tax on the majority of items they buy for their company. Anyone who buys rental properties has to pay a property tax each year.
This essentially means that investors help fund the government by creating opportunities for new tax payments. They hire employees and pay a property tax on their investments. Because of this, tax incentives target investors, self-employed individuals and business owners. By giving these groups tax breaks, the government hopes to encourage other activities that will generate tax revenue.
How Can Investors Save Money on Their Tax Bills?
There are a number of tax benefits you can enjoy as a property owner. Deductions, the 1031 exchange and depreciation can help you lower how much you pay to the federal government. Because the tax code is fairly complex, it is important to get professional advice about your unique situation before you claim a new deduction or credit.
Deductions
Because you own an investment property, you can now take advantage of new deductions. Whenever you file your tax bill each year, you can deduct costs like your mortgage interest and repairs. You may also be able to deduct your business expenses as well.
Deducting mortgage interest is generally the largest deduction that taxpayers get, but it also applies to investors as well. If you own an investment property for passive income, you can take advantage of this deduction. In addition, this deduction works for home equity loans, refinanced mortgages and lines of credit.
To claim the mortgage interest deduction, you will need your Form 1098 from your mortgage lender. This form will show how much you paid in tax costs for the year as well as how much money you can deduct. The deduction also works for any payments or insurance premiums that went through an escrow account.
Property Improvements
While improvements help you boost your property’s value, repairs are designed to keep your property in working order. According to the tax code, you can write off your repairs right away. Because improvements add value over time, the value has to be depreciated over multiple years. The type of improvement determines how long it takes to depreciate the cost.
Business Expenses
If you are actively investing and managing your property, you should be able to deduct almost all of the expenses associated with running your business. For example, you can deduct the cost of your internet bill and phone bill. You may also be able to deduct your travel costs each time you go to view the property.
1031 Exchange
When you use a 1031 exchange, you can basically delay your tax bill until you sell your property. Normally, you have to pay taxes on your capital gains whenever you sell a property. Through a 1031 exchange, you can delay this tax payment. Instead of paying a tax bill, you can invest those funds in another property. A 1031 exchange basically lets you exchange your first property for another property without paying a capital gains tax on it.
To get this tax benefit, the new property must meet certain eligibility criteria. It must be a like-kind exchange. This means that the new property must have the same class or character. If you originally sold a residential property, you should also be buying a residential property. In addition, the new property must have a value that is the same or greater than your previous property.
To qualify as a 1031 exchange, you must also purchase a new property right away. You have 45 days to identify a new property after you sell your original property. Then, you must close the deal on the new property within 180 days of the sale of your first property.
Finally, a 1031 exchange requires a qualified intermediary. You are not allowed to handle the transaction or money by yourself. The intermediary must not be someone you have worked with in any capacity over the previous two years.
By using this technique, you can postpone your tax bill. In addition, you get to reinvest your profits into a new property. Because of this, you basically get to earn profits from your postponed taxes until you eventually sell the new property. As long as you never divest completely, you can keep using a 1031 exchange to postpone your capital gains tax.
Depreciation
As buildings age, they start to break down. The Internal Revenue Service (IRS) calls this process depreciation. To accommodate for wear and tear, the IRS lets investors depreciate the value of their assets over time. This allows you to reduce your overall tax liability.
You can depreciate the value of a residential property over 27.5 years. For commercial properties, you can extend depreciation over 39 years. For example, we will assume that you have a residential property worth $400,000. You can depreciate 85 percent of the property’s value. Because land is 15 percent of the property’s overall value, you cannot depreciate the last 15 percent. Land does not break down in the same way that buildings do, so the value theoretically remains the same.
For the next 27.5 years, you will be able to depreciate 85 percent of your original investment. This works out to $340,000 in total. Each year, you can depreciate $12,363.60. Even if you exclude other tax breaks, this works out to a hefty tax reduction. If your property normally brings in $1,000 a month in rental income, the depreciation creates a net operating loss. On paper, you are effectively losing money each year. In reality, you are bringing in $1,000 a month and will eventually profit through the sale of the building as well.
Passive Income and Real Estate Investing Can Lower Your Tax Bill
When you invest in real estate, you get to use a range of different tax deductions and credits. By using these tax benefits, you can end up saving a significant amount of money each year. In order to realize these savings, you just have to do some tax planning in advance. Our video interview between Slocomb and Phil is a perfect example of putting these tax strategies into action. With the right planning, you can use your tax savings to fund your passive investing in the future.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.