Top 3 Investment Property Tax Benefits You Should Know About
As an investment property owner, you have access to a vast array of tax benefits. The tax code is complex, so it will save you time and trouble to hire a tax professional to take care of your taxes each year. However, it behooves you know about the following three top tax benefits so that you can leverage them as the year progresses. After all, it’s no good finding out after the fact that you could have done this or that the previous tax year. Here are the top three investment property tax benefits to know about.
The 1031 exchange is one of the most powerful tax benefits you should know about. If you’re interested in creating or building a real estate portfolio, this is a tax break you should be utilizing. Essentially, this provision in Section 1031 of the IRS Tax Code permits real estate property sellers to defer capital gains tax indefinitely. This is a smart investment strategy even if you only plan to hold one property at a time, in succession. There are many rules about qualifying for the 1031 exchange tax break, but they are fairly straightforward. They include:
- the property must be for investment purposes (no owner-occupied or flips)
- properties must be like-kind
- the replacement property must be identified within 45 days of closing on the current property
- replacement property closing must be within 180 days of closing on the current property
- replacement property and current property must be in the same owner’s name
Finally, a critical rule regarding a 1031 exchange is that you must use a qualified intermediary such as a real estate attorney or a tax accountant to manage all funds, including disbursements. At no point in the transaction should the funds be in your control other than to direct the sale and purchase.
For this reason alone, it’s advised that you hire a professional to assist with your 1031 exchange activities. There are also other 1031 exchange rules that your professional intermediary can assist you with. Remember that the 1031 exchange provision is indefinite. Should you decide to hold an exchanged property for a lifetime, your heirs don’t pay capital gains either. If they decide to sell, they would only pay taxes on the actual and current value of the property. Otherwise, they could choose to continue the 1031 exchange activity, and also avoid paying capital gains tax indefinitely. You can now see how this tax benefit is a powerful investment and estate planning tool.
Depreciation is a close runner-up to first place in terms of investment property tax benefits you should know about. You can claim depreciation as long as your property is for investment purposes; even if you don’t own the property under a business entity. The IRS offers depreciation as a tax benefit under the principle that property always depreciates over time. While this is true theoretically, your investment property may give you positive cash flow. Since depreciation is a non-cash deduction, you can make money on your property and still get a big tax break on that profit through the depreciation deduction.
So what’s depreciable? Any physical thing that you spend money on that has a life expectancy of at least a year. This includes expenses like a new roof, a driveway, a sidewalk, kitchen countertops, flooring, etc. The biggest depreciable expense is the actual purchase price of the property. Note that this doesn’t include the land since land is not considered to lose value due to wear and tear. You have to separate the land value from the building value to calculate the depreciation benefit. Furthermore, you need to calculate using the IRS determined “useful life.” The useful life of a residential property according to the IRS, is 27.5 years. Other items don’t have the same useful life just because they’re “connected” to the property. A furnace doesn’t have the same determined useful life as a sidewalk or a countertop, or an apartment building. Each expense has to be calculated independently. If it sounds complicated, that’s because it is. That’s also why so many real estate investors miss out on this top investment property tax deduction. If you own investment property, work with a qualified tax professional to ensure that you get your depreciation tax benefit and that it’s calculated correctly.
Finally, interest is one of the top three investment property tax deductions you should know about. As you know, interest costs can really cut into your profits and your budget. Depending on where you got the loan to purchase your investment property, you could be paying interest at multiple times the standard rate. Often, investment property owners forget all the forms of interest expenses they can deduct on their tax forms. Here are some you may not have thought about:
Mortgage Interest – you can deduct the interest portion of your monthly payment
Points and Loan Origination Fees – not traditional interest, but fully deductible on the interest deduction line on your tax form
Loan Interest – if you got the purchase money from an alternative source, such as a hard money lender, you can deduct that interest amount
Credit Card Interest – you can deduct the interest for any purchase you made for the property which you paid with your credit card
Allowable interest deduction regulations sometimes change over the years. Therefore, it’s advisable to use the services of an experienced tax accountant for the preparation of investment property taxes.
These are the top three investment property tax deductions you should know about, at a minimum. Your professional tax advisor should be able to ensure you take full advantage of all the deductions you’re entitled to, including some that are state specific. Remember, owning real estate investment property is one of the most rewarding and reliable ways to build wealth. Being knowledgeable about your tax benefit entitlements is an important part of that strategy. For more information about building wealth with real estate, please contact us today.