The Real Estate Game: How Real Estate Investors Pay Little To No Taxes
Real estate investing is well-known for its tax benefits. Many running expenses are tax deductible, which is one of the features that attracts so many people to real estate investing. However, tax deductions aren’t the only factor to consider when it comes to real estate taxes.
Owning Real Estate in a Self-Directed IRA is a great way to start.
An IRA is a type of retirement account that you’ve probably heard of. An Individual Retirement Account (IRA) is a popular retirement plan in which you make regular contributions to an investment that will eventually support your retirement. You get to choose which investment your money will go into when you start an IRA. The best thing about an IRA is that you don’t have to pay taxes right away on your contributions. Instead, you only pay taxes on your IRA withdrawals once you’ve retired.
Keep your Real Estate properties for over a year.
Holding a property for at least one year is one of the easiest methods to lower your tax burden. You could desire to buy and sell properties as quickly as possible if you’re a house flipper. However, holding your assets for at least a year before selling can be more profitable.
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Buying and selling for a short period of time is called a business. You must also pay FICA taxes, which are payments set aside for Medicare and Social Security because you’re a business.
Avoid Federal Income Taxes (FICA)
If the IRS considers you a self-employed real estate investor, as described in the previous section, you will be required to pay FICA taxes. If you can show “investment intent,” you can avoid these taxes. In other words, you’re demonstrating to the IRS that you’re only trying to raise money for other projects and that this isn’t your usual business practice.
The following are examples of investment projects:
- Making improvements to your investment
- Putting a deposit down on a long-term rental
Taxes can be deferred via a 1031 Exchange.
A “like-kind exchange,” as defined by Section 1031 of the tax code, allows you to avoid paying taxes on a property transaction for an extended length of time. All you have to do now is use the funds from the sale to purchase a similar property.
If you sell an investment for $100,000 more then you bought for you can defer paying capital gains if you use the profit to buy another investment (the $100,000 will be used as a down payment).
Owner Financing
What if you make a profit on a sale but don’t want to spend the money on a new house? You’d have to pay capital gains tax in such case, and you might also have to pay more income tax.
Some investors prefer to use seller financing to sell a property. You provide a loan to the person who is buying your home through seller financing.
You’ll only have to pay taxes on the buyer’s down payment and principal, but no capital gains tax because you didn’t get all of the money up front. Instead, the buyer is paying you over time for the outstanding sum. You can also profit from the buyer’s interest; thus, seller financing can be extremely rewarding.
Mortgage Interest Can Be Deducted
Many real estate expenses are tax deductible. Here are some of the real estate tax deductions you can claim:
- Mortgage insurance is a type of insurance that protects
- Homeowners’ insurance
- Taxes on real estate
- Fees for property management
- Advertisement costs
- Fees for legal representation
- Costs of upkeep
- Expenses for a home office
- Business travel expenses
The best part about these tax breaks is that you don’t have to itemize your deductions to take advantage of them. Many of the expenses listed above can be deducted in addition to the standard deduction. These deductions can help you save a lot of money on your taxes.
Pass-Through Deduction of 20%
Small business owners can deduct an additional 20% of their net income. The 20 percent pass-through deduction is what it’s called.
Because this tax break is intended for small businesses, there are income limits: married couples can deduct $315,000 and single filers can deduct $157,000.
If you’re unsure whether or not you may claim this deduction, it’s a good idea to seek advice from a tax professional.
Natural deterioration and wear and tear cause properties to devalue. As a result, the IRS permits you to depreciate each of your investment properties.
The IRS determines a residential building’s lifespan at 27.5 years so that you can deduct 1/27.5th of the property’s value each year for the first 27.5 years.
For example, if your home is worth $300,000, you can claim a tax deduction of $10,909 for the first 27.5 years that you own it. (27.5 / 300,000)
Borrowing Against Your Investments Equity
Have you built up a substantial amount of equity in a property? You can take money out of your property’s equity and use it to fund another real estate venture.
Some investors may opt to sell the property and utilize the earnings to fund a new investment, although this would likely result in capital gains tax. You may maintain your home, avoid paying capital gains, and gain income to fund a new investment by borrowing against your home equity.
Most lenders will let you take out 80 percent to 85 percent of the equity in your property. Because you’re losing equity in the home and adding to your debt, there’s some danger involved, but you can reduce it by renting out your house to tenants.
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Adding up all of your expenses.
As you may have noticed, developing a tax strategy is more difficult when you don’t keep track of all your real estate spending. Keep meticulous records of all your expenses, especially if you plan to claim tax breaks.
There are numerous real estate apps available that can assist you in keeping track of your spending and even preparing for your annual tax file. Make sure you have at least one of these apps in your real estate investment toolkit.
No taxes by inheritance
When you die and own property, your “original foundation” on the property vanishes. In other words, the amount you paid for the property at the time of purchase is no longer relevant. Furthermore, your heirs are exempt from paying capital gains taxes on the property.
Your assets will be appraised and assigned a new market value shortly after you die. If your heirs decide to sell the property, they will not have to pay capital gains taxes on the proceeds.
Let’s say you paid $200,000 for the house when you first bought it. When you pass away, your property is appraised and valued at $300,000. The property is sold for $350,000 by your heirs.
In normal conditions, $150,000. would be subject to capital gains tax. But not if you were to die. Your heirs are free to keep the 350,000 profit and avoid paying capital gains taxes.
At the closing table…
If you want to succeed in the game of wealth, you must first understand the rules. And nowhere is this more evident than when understanding how to lower your taxes.
Learn how to take advantage of the tax benefits available to real estate investors. They can save you hundreds of thousands of dollars or more over the course of your life, allowing you to devote more of your money into growing wealth.
Not only will you escape paying taxes on the profits and depreciation recapture if you keep your assets until you die, but your children will inherit them tax-free. By any measure, that’s a winning legacy to leave behind.
