Five Primary Real Estate Strategies For Tax Advantages

The tax code provides for several real estate tax strategies for minimizing tax liabilities or generating refunds. Some of these concepts are well-established and time-tested, while others are relatively recent additions.

1. Depreciation

Depreciation is the recovery of costs to maintain investment properties through annual tax deductions. Over time, the real estate will begin breaking down, and the depreciation deduction is in essence a recompense for the “wear and tear” of the property. For tax purposes, depreciation is always considered a net loss on the real estate investment independent of any profits realized on the property.

The allowed deduction amount is determined by the property’s market value, the property’s recovery period and the depreciation method used. The most commonly used depreciation method is called the modified accelerated cost recovery system, which allows investors to deduct depreciation on a residential property and commercial real estate for 27.5 years and 39 years, respectively.

2. Self-Employment/FICA Tax

While rental income is taxable as standard income tax, it is not subject to these FICA taxes. Even if you are self-employed, any income relating to a rental property is immune to both the social security and Medicare taxes you would otherwise pay on either a 1099 or W-2.

3. Opportunity Zone Funds

The Tax Cuts and Job Act of 2017 includes a tax incentive for investing in the country’s most rural and financially distressed areas. The act designates nearly 9,000 of these areas as Opportunity Zones, in which investors can put the capital gains earned from selling other investment properties as a means to defer capital gains tax on their original investment.

The buyer often presents a bump clause to the seller in the hopes it will influence the seller to accept an offer with a contingency. Otherwise, trying to buy a home while selling your home at the same time can be a hardship. While the concept of a bump clause does not initially seem advantageous to the buyer, it can present opportunities not otherwise available.

4. 1031 Exchange

A 1031 Exchange is the exchange of one real estate investment property for another similar property. A qualifying exchange will have either zero or minimal tax liabilities, unlike most asset swaps that are taxable at the point of sale.This means you can roll over capital gains from one real estate investment to another, avoiding taxes until you sell the property – so long as you hold the asset for at least one year. In other words, capital gains taxes are only paid upon a final sale of a property that includes no exchange.

5. Passive Income And The Pass-Through Deduction

As it relates to real estate investments, passive income is any money that is earned from rental-related business activities in which the investor does not actively participate.Owners may be able to deduct up to 20% of the net rental income received, or 5% of the original cost of the property plus 25% of employee payroll expenses.This deduction, established in 2018, is related specifically to income tax and is unrelated to rental deductions. This special income deduction is scheduled to expire in 2025.

In Summary

While retaining a knowledgeable CPA is recommended and will help alleviate the stress, having a general understanding of these strategies and a thorough record of your real estate investment-related expenses will aid in those conversations, minimize your CPA costs and make your tax filing much easier.

Steve Byrne, Forbes May 20, 2021