Author: Ronica Brown. | Estimated Reading Time: 2 minutes
Some interesting patterns have been emerging in the US real estate market since the pandemic.
According to the PricewaterhouseCoopers 2021 Emerging Trends in Real Estate report, “real estate prices are expected to fall by 5 to 10% and industrial properties, data centers, and single-family homes are expected to rise in value.”
Zillow’s Home Value Index also indicates that “United States home values have gone up 11.6% over 2020 and [Zillow] predicts they’ll rise by 11.8% in 2021.”
You’re probably considering investing in real estate for four reasons. You want to:
Reap the benefits of low prices and increasing value
Pass on generational wealth
Increase your net worth
Buying real estate for investment can help you pay less taxes as a business owner if you know how to access the powerful tax benefits of investing in real estate.
The process begins with seven important questions.
7 Questions to Ask When Buying Real Estate For Investment
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There are seven questions you should ask yourself if you want to reap the tax benefits of investing in real estate.
1.What Type Of Real Estate Are You Buying?
You should view your real estate investment as a complete business activity. This allows you to make profitable investment decisions and scale your investment portfolio even faster. Carefully consider the types of properties you want to specialize in buying so that you can scale your investment. Some options include:
Single-family dwellings
Multi-family dwellings such as apartments
Commercial office space
Commercial retail space
Parking lots/other exterior property
Land
2. What Are You Trying To Achieve With Your Real Estate Investment?
The most common real estate investment options are:
Renting (Buy and Hold)
Flipping (Buying and Selling)
Real Estate Syndication (investing in other real estate ventures)
Real Estate Investment Trusts (REITs)
The option you choose ultimately depends on your goal for buying real estate for investment. The goal is different for each investor. For example, some investors may just want to create passive income over time while others may be more interested in value appreciation.
Your end goal for your investment will help you make decisions more quickly about when to sell a property, when to hold (or how long to hold), when to add more properties, or when to even sell and move to other types of property investment.
Once you’ve decided what your investment goals are, you can move on to building a team that will help you scale this investment. You can also determine the return you’re expecting from the investment.
3. What Return on Investment (ROI) Are You Seeking?
You’re investing in real estate expecting a return on your investment. Just like any other business, you should start off with your research to determine what ROI you should be expecting. Real estate investment can easily blow up and create a cash flow nightmare if it’s done wrong. So, proper planning and research will go a long way.
How you measure your ROI will determine either how you use the property or your business model for investing.
Two of the simplest real estate business models include:
Buy and hold for more than one year
Buy and sell within the same year (aka flipping real estate)
Your return should be determined based on your real estate investment goals and how long you intend to hold the property. The ROI for rental properties is normally measured using capitalization rates (aka cap rates).
But, investors who flip real estate properties would most likely be interested in after repair value (ARV). The ARV strategy helps you determine how much you’ll pay for repair costs so that you can determine whether this would be a good deal based on the expected percentage return.
Understanding your required ROI will also help you determine the types of properties to buy and help narrow down your list of potential types of investments. This will help you make quicker decisions.
Real estate requires a lot of capital. So, never go into real estate investment blindly without analyzing the deal and understanding the type of ROI you should be expecting.
4. Are You Holding The Property For The Short Term And Then Selling It?
The holding period for your property determines how it will be taxed after liquidation. You can discuss your holding period with the team at RBA Tax Advisors so that we can create a holistic tax savings plan for your real estate purchase. We’ll ensure that you use the right taxable entity so that your capital gains tax on real estate is either reduced or eliminated.
5. What Is Your Real Estate Business Model?
The rise of lodging businesses, such as Airbnb and Vrbo, in recent years has resulted in a different type of business model for the long-term hold of real estate. A business model in this sense refers to how the business will generate cash flow to meet its cash flow goals.
If you compare a traditional rental property with an Airbnb rental, you may find that the Airbnb property generates more short-term cash flow. Does this meet your goals?
Having a traditional tenant provides passive income. It’s also less work when compared to an Airbnb and creates more consistent monthly income. Some additional benefits include you:
Having more options
Choosing how you want to run your real estate business to meet your goals
There are also some important considerations that you should pay attention to when choosing your real estate business model:
Access to capital and financing
The number of properties you need to help meet your goal
Your price point
The number of properties you should acquire annually
Your required ROI
The tax benefits of investing in real estate. How can you use real estate to reduce your tax rate? Do you need more passive income or losses?
Tax savings are great, but you’ll only truly experience the tax benefits of investing in real estate when your venture is profitable and produces consistent cash flow. That’s how you’ll keep more money in your pocket!
6. Can Buying Commercial Real Estate Help Increase Your Tax Deduction?
Your depreciation-related deductions depend heavily on whether you’re buying commercial or residential property. Both forms of real estate benefit from depreciation but you can access more depreciation savings with commercial real estate.
There are two tax planning considerations with commercial real estate:
You operate your business from your commercial real estate property
The property is completely leased to third parties
An experienced tax advisor can walk you through the tax planning considerations in both scenarios. It may even be possible to include commercial real estate investment as part of your tax savings plan.
Investing in commercial property creates higher tax deductions upfront because you can do a cost segregation study on your property. This will help you speed up depreciation. So, you’ll have larger tax deductions in the earlier years of owning the property.
A cost segregation study is usually not available for residential real estate. But, accurate depreciation on land and buildings can also create significant cash flow for residential real estate owners.
7. Real Estate Dealer Vs Investor…Which Should You Choose?
It’s important to discuss the difference between a real estate dealer and a real estate investor. A real estate dealer buys more than one property to sell within a year. But, a real estate investor buys less properties (typically only one) and holds them for the long term.
There’s a clear difference between the business models and how they are taxed. A real estate dealer has a higher tax rate and pays self-employment taxes because the IRS views this income as ordinary income. But, a real estate investor has a lower tax rate, pays no self-employment taxes, and only pays capital gains taxes when selling a property.
You can learn more about the important differences between a real estate dealer vs investor in the video below.
Now that you’ve asked those seven questions, it’s time to focus on the five powerful tax benefits of investing in real estate.
5 Powerful Tax Benefits Of Investing In Real Estate
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Deduction for the Cost of Operating Your Business
Similar to other business activities, your real estate investment allows you to deduct the cost of operating your business. You get these deductions regardless of the type of property you own and how you deal with your real estate investment. The day to day expenses that you can deduct include:
Real Estate Taxes
Mortgage Interest
Mortgage Insurance Premiums
Property Insurance
Property management Fees
Repairs and Maintenance
Home Owners Association fees (HOA)
Utilities
Depreciation
You can also get additional deductions depending on your business model. These deductions include:
Mileage
Home Office Deduction
Supplies
Furnishing items for a furnished rental
2. Depreciation Write-Offs
Depreciation is the best part of real estate investment. Depreciation allows you to deduct the costs of your fixed assets (such as buildings) over time. Tax rules don’t allow you to deduct these costs upfront.
Congress and the IRS control how much you can deduct in any given year and the rules can change from year to year. It can take at least 27 to 40 years to completely claim a write-off based on the cost of your real estate investment.
Land is also not deductible so tax preparers will also need to break out the cost of land versus the cost of the property. Your depreciation amount will be reduced since land is not deductible.
Most CPA and tax preparers will just use an arbitrary 20% or 30% of the total purchase price for the land. This can be a costly mistake since you cannot deduct any portion of the land purchase price.
The team at RBA Tax Advisors has corrected so many returns via the process of method change. Our clients were then able to claim additional depreciation that was incorrectly assigned as “land value”. This type of correction can result in $25,000 or more in tax savings.
This type of depreciation is tax-free cash. Let’s say you purchased a $1,000,000 property. The land’s value is $100,000. Land doesn’t depreciate so its value should be removed from the purchase price.
This leaves you with only $900,000 for depreciation. So, your property depreciation would be approximately $33,000 annually assuming a 27-year straight-line depreciation. How you chose to finance the property purchase (debt or cash) doesn’t matter.
So, the $33,000 is actual cash from your annual cash flow that you don’t have to pay taxes on.
The $33,000 depreciation value each year is based on your initial purchase price less the land’s value. So, you get this deduction without having to spend more cash each year.
Accelerated Depreciation For Commercial Property
Let’s say you purchased commercial property.
You purchase for $1,000,000
Land Value is $100,000
Depreciation is 39 year Period
You can do a cost segregation study that allows you to accelerate depreciation for this commercial property in the first year you purchase the property. When a property is purchased, not only does it include a building structure, but it also includes all its interior and exterior components. On average, 20% to 40% of those components fall into tax categories that can be written off much quicker than the building structure.
A cost segregation study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years. It allows more depreciation upfront since all components of that property are annualized separately.
Let’s say you get a cost segregation study completed and you find that you can speed up depreciation for this commercial property by an additional $250,000 of your total purchase price.
Your total depreciation for that year would be $250,000 for the first year. Without this type of analysis, your depreciation would be approximately $23,000 per year (less than the depreciation for residential property).
Larger purchase prices (and a wider distribution of properties) increase your depreciation write-off. These numbers become extremely large when you’re dealing with commercial properties, multi-family residences (such as apartments), and several residential properties.
What If You Already Purchased Your Property And Didn’t Do A Cost Segregation Study?
The team at RBA Tax Advisors has done a lot of work in this area. We start by reviewing the tax returns for prior years. Our analysis may reveal that a new client did not:
Use a cost segregation study
Assign the correct land values
Use the right depreciation method and years on other assets
We fix this by filing a change in accounting method for the taxpayer. This correction allows you to deduct all the expenses you missed out on that are related to your depreciation. You benefit from accelerated depreciation and reduce your taxes.
We recently helped a business owner access $380,000 in accelerated depreciation. His tax rate was 37% (federal and state) so this resulted in a tax refund of $136,800.
Get a free tax return review if you already purchased a property and didn’t do a cost segregation study. This review helps you get your entire return analyzed. Never get a cost segregation study as a one-off service because you may be leaving more cash on the table due to other depreciation and/or adjustments that could be corrected on your return.
3. Leveraging Debt
Leveraging debt means that you’re using good debt to finance investment activities. You don’t have to use your cash when buying real estate for investment. Instead, you could acquire a loan for your real estate investment.
This strategy allows you to access multiple properties and scale your investments. You can increase your cash flow, tax deductions, and net worth if you leverage debt the right way. You’ll also get a higher depreciation write-off.
You’ll experience slower investment growth if you want to own real estate without debt (unless you have access to limitless cash). But, interest rates are low so now would be the best time to use your cash for an investment that yields high returns while using debt to purchase real estate. The interest you pay on that debt will also be tax-deductible.
Debt is completely tax-free. So, the money you receive from a loan isn’t taxed. Also, any cash received from refinancing is tax-exempt.
The other awesome thing about debt is that the interest paid on the debt is deductible. So, you get tax deductions for using debt to grow your real estate portfolio.
4. Avoiding Self Employment Taxes
All business activities are subject to self-employment tax. This type of tax consists of Social Security and Medicare taxes for individuals who work for themselves.
It’s similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. This tax is 15.3% on income up to $142,800 in 2021.
You aren’t subjected to this self-employment tax when your real estate investment is considered passive. Passive real estate investment includes:
Renting (Buy and Hold)
Real Estate Syndication that holds rental real estate
Buying shares in Real Estate Investment Trusts (REITs)
Your real estate investment can also help reduce self-employment taxes on your other business income. For example, let’s say you’re a medical doctor with a medical practice and you also own real estate in a separate legal entity. You can increase your rent payments to that separately owned property so that your self-employment tax on your income from operating the medical practice decreases.
The best way to identify these types of opportunities is to speak with a tax advisor. Schedule a call with me so that my team and I can help you use your real estate to reduce your self-employment taxes.
5. Deducting Passive Losses
Real estate investment is a passive activity according to the tax laws. This means that your net income is fully taxed as ordinary income and you can’t deduct any losses you incur that exceed your passive income.
Here’s an example. Let’s say you own residential rental property and these are your numbers:
Rental Income $35,000
Depreciation -$10,000
Operating Expenses - $15,000
Net Profit is $35,000 - $10,000 - $15,000 = $10,000
The entire $10,000 is taxable. You will pay ordinary income tax on this profit, not capital gains taxes.
Let’s say your expenses were higher.
Rental Income $35,000
Depreciation -$20,000
Operating Expenses -$15,000
Repairs and maintenance - $5,000
You would have lost $35,000 - $20,000 - $15,000 - 5,000 = -$5,000. This $5,000 loss is what’s called a passive loss. Your ability to deduct from this amount depends on your total income and whether you have other passive income to offset this amount.
Most real estate investors don’t have additional passive income to utilize. This is where planning around passive income loss comes in. We do extensive planning in this area to ensure that our clients who invest in real estate can fully deduct these passive losses each year.
The IRS has two requirements when it comes to passive losses. First, you must be an active participant. You would have to spend a certain number of hours working in real estate to fall into this category. This could mean that you are managing your properties while simultaneously carrying out other functions.
An active investor can use up to $25,000 of passive losses every year to offset any other type of income. The trick here is that there are income limits that apply to this benefit. Also, most seasoned real estate investors will have more than $25,000 in losses, especially if they’re investing in multiple properties and have commercial real estate.
The second requirement is that you must become a real estate professional. This requirement can become quite muddy and requires careful planning. There are two requirements for you to be considered a real estate professional. First, more than half of the professional services you performed during the tax year must fall within the gamut of real property trades or businesses in which you materially participated.
Second, you must perform more than 750 hours of service during the tax year related to real property trades or businesses in which you materially participated. This even includes businesses where you only have a 5% ownership stake.
Let’s outline what “real property trades or businesses” means. The term includes any of the following activities done to real estate property:
Developing or redeveloping
Constructing or reconstructing
Acquiring
Converting
Renting or leasing
Operating or managing
Brokering
If you have multiple properties, each property needs to qualify on its own unless you file an election to aggregate all your real estate investment activities.
How To Get Around Passive Loss Rules
The two requirements previously mentioned can be difficult for most real estate investors to meet. But, careful planning around all your passive activities will help you deduct all your losses. Planning items include:
Using a Passive Income Generator (PIG)
Grouping activities and aggregating investment activities
Self-rental Combined with Grouping election
Other tax elections that can make these deductions easier each year
The simplest strategy for bypassing passive loss rules is either you or your spouse qualifying as a real estate professional so that you can deduct all your losses. But, what if you still don’t qualify because you have other businesses in different industries such as a medical practice, retail store, or engineering firm? Then you can group elections and create Passive Income Generators (PIGs).
A PIG allows you to use one of your other businesses to create passive income. You can then deduct these passive losses. Schedule a call with us and we can discuss the ways for you to create a PIG to use these losses.
How to Avoid Capital Gains Tax on Real Estate
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Real estate investing has its perks. But, some real estate investors bemoan the capital gains taxes they must pay on their real estate profits. Taxes paid on capital gains are normally lower than taxes paid on any other tax you are paying on your business income.
What Are Capital Gains?
A capital gain is an increase in the value of an investment when individuals and businesses sell those investments. The gains are called a realized capital gain when the assets are sold.
You earn capital gains from real estate when you sell any type of real estate property you own. But, there are some exceptions.
The sale of your personal home isn’t subject to capital gains taxes if your gains are below $250,000 for individuals or $500,000 for those who’re married and filing jointly. If your gains are higher than these amounts, you have to pay capital gains taxes on the sale.
If you are buying, fixing, and selling, this is not a capital gain activity even if it took you more than a year to complete this process before the sale. The tax law considers this activity to be active trade which is subject to ordinary taxation, not capital gains taxes.
The real issue comes when you have high capital gains because of large real estate investments. This is a great problem to have since the capital gains rates are much lower than other tax rates.
Tips For Avoiding Capital Gains Taxes On Real Estate
There are multiple options available to help you either reduce, defer and/or eliminate these capital gains. One of the most common strategies is doing a like-kind exchange where the IRS allows you to sell real estate and then buy equivalent real estate.
Doing this allows you to defer taxes to a later date. Please note that this strategy doesn’t eliminate your taxes. You’re just asking for more time until you’re ready to completely liquidate your real estate holdings.
What If You’re Ready To Liquidate Your Real Estate Investments?
Trust and entity planning are two other strategies you can use to reduce and avoid capital gains tax on real estate. Both strategies involve restructuring your liquidation activity so that it falls within the rules for tax-free activity.
Other strategies also exist. That’s why it’s important to speak with a knowledgeable tax advisor. The RBA Tax Advisors team is ready to find the strategy that works best for you and your business. Schedule a call so that we can begin the planning process.
The strategy we use to reduce or avoid capital gains taxes will depend on your long-term goals. Here are some questions that we’ll ask:
What does real estate investing mean to you?
Do you want to pass down real estate assets to your children?
Do you want to liquidate and move on to other projects?
Your end game will help us build a strategy that allows you to reduce your cash flow while paying less taxes. We ensure that your capital gains reduction solution aligns with your overall tax savings plan.
Final Words
A tax advisor can help you tap into the tax benefits of investing in real estate. Many options are available, but the best options allow you to:
Maximize your real estate tax deductions
Access depreciation write-offs
Leverage debt
Avoid self-employment taxes
Deduct capital losses
Minimize capital gains taxes
Schedule a call with me and we’ll discuss how my team and I can help you reap the tax benefits of investing in real estate for your business.