Most people look forward to getting a big tax write-off when they buy their home. What they don’t realize is that tax deductions are even more favorable when buying investment property.
Here are 4 ways you can reduce your tax bill when buying real estate that is treated as a rental property:
1. Deducting Direct Costs
Investors who own rental property can deduct the costs of maintaining and marketing the property. These include: mortgage interest, insurance, taxes, utilities, maintenance repairs, advertising costs, and professional fees. You can only deduct your mortgage interest and taxes on your primary residence.
Depreciation is calculated under the theory that assets lose value over time as they wear out. According to the IRS, furniture, appliances, and other household items “lose all value and become virtually worthless” after 5 years. Obviously, these items can last longer than that, but the IRS says we can treat it “on paper” as if they don’t.
Let’s say you bought a refrigerator for $1000. You could divide the cost by 5 years, and then write off $200 per year as depreciation on that item. You can also use accelerated depreciation for personal property which will generate higher deductions in the earlier years of that assets depreciable life.
Depreciating real estate is similar. Since land does not “wear out,” the value of the land is then deducted from the price you paid for the real estate. The remaining structure can then be depreciated over 27½ years. For example, if you bought a $100,000 home, you would subtract approximately $20,000 for the land and then depreciate the remainding $80,000 structure. Then you would divide $80,000/27.5 = $2909. This means you get to write off $2909 every year for 27.5 years.
3. Trade in, trade up
The tax code allows homeowners to exchange one piece of property for another without having to pay capital gains tax. You might not think an investor with a long term outlook would ever need this, but here’s an example of what could happen.
Say you bought a vacant lot 40 years ago for $10,000 and it’s now worth $500,000, selling it could cost you more than $100,000 in federal and state income tax. However, if you exchange the lot for another piece of real estate of equal value – let’s say an income producing property — then you would be able to continue to defer the capital gains tax.
Many investors say, “Defer ‘til you die.” When your heirs inherit the property, the tax basis is usually stepped up to market value so if they sell, they would not pay the capital gains tax either.
4. Active investors win more
Passive investors can only deduct passive losses from the rental income or other passive income they earn. Even though the list of losses might be higher than the rental income, especially if depreciation is included, it cannot be deducted from other sources of income if you are a passive investor.
However, if an investor is actively involved in the management of the property, he or she could have unlimited deductions from their real estate and use those deductions against any of their earned income.
In order to qualify for unlimited deductions, you have to prove to the IRS that you are a real estate professional. This doesn’t mean you have to be an appraiser, inspector, or real estate agent selling houses.
To the IRS, a real estate professional means you spend more than 750 hours a year buying, selling, renting and managing your properties or performing similar services for your clients. To qualify, you cannot have another job that takes more than 750 hours of your time annually.
If the investor does not qualify as real estate professional according to the IRS, but is still actively involved, he or she can still deduct up to $25,000 from any earned income to compensate for passive losses incurred – as long as the investor has less than $100,000 per year adjusted gross income. Folks who have more than $150,000 per year in adjusted gross income cannot qualify for this benefit – however, the losses can be used in the future during a year when the investor earns less than $150,000. In addition, any passive income received can be sheltered by your passive loss carryovers.