How investment in real estate can save on taxes?
Investing in real estate offers a multitude of tax benefits that can significantly reduce an investor’s tax liability. This article explores the various tax advantages associated with real estate investments, including depreciation, mortgage interest deductions, 1031 exchanges, capital gains exclusions, the impact of holding periods on tax rates, passive activity loss rules, the benefits of real estate professional status, and relevant tax credits or deductions.
Depreciation
Depreciation is a powerful tax benefit that allows real estate investors to deduct the cost of the property over its useful life. Under the Modified Accelerated Cost Recovery System (MACRS), residential rental property is depreciated over 27.5 years, while nonresidential real property is depreciated over 39 years. The Tax Cuts and Jobs Act (TCJA) introduced a new class of depreciable property known as “qualified improvement property” (QIP), which includes improvements to the interior of nonresidential buildings. QIP is depreciated over 15 years under the General Depreciation System (GDS) and 20 years under the Alternative Depreciation System (ADS) [4].
Mortgage Interest Deductions
Mortgage interest on loans used to acquire, construct, or substantially improve a qualified residence is deductible. For tax years 2018 through 2025, the mortgage interest deduction is limited to interest on acquisition indebtedness up to $750,000 for married taxpayers filing jointly ($375,000 for married individuals filing separately) [5]. This deduction can significantly reduce taxable income, especially for high-value properties.
1031 Exchanges
Section 1031 of the Internal Revenue Code allows real estate investors to defer capital gains taxes on the exchange of like-kind properties. To qualify, the properties exchanged must be held for productive use in a trade or business or for investment, and the exchange must be completed within 180 days of the transfer of the relinquished property [1]. This deferral can be a powerful tool for investors looking to reinvest their gains into new properties without immediate tax consequences.
Capital Gains Exclusions
The sale of a principal residence can qualify for a capital gains exclusion under Section 121 of the Internal Revenue Code. Taxpayers can exclude up to $250,000 of gain ($500,000 for married couples filing jointly) if they have owned and used the home as their principal residence for at least two of the five years preceding the sale [5]. This exclusion does not apply to vacation homes or rental properties unless specific conditions are met.
Impact of Holding Periods on Tax Rates
The holding period of a property affects the tax rate applied to capital gains. Short-term capital gains (on properties held for one year or less) are taxed at ordinary income tax rates, while long-term capital gains (on properties held for more than one year) benefit from lower tax rates, typically 0%, 15%, or 20%, depending on the taxpayer’s income level [7].
Passive Activity Loss Rules
Under Section 469 of the Internal Revenue Code, rental real estate activities are generally considered passive activities, and losses from these activities can only offset passive income. However, there are exceptions. For example, taxpayers who actively participate in rental real estate activities can deduct up to $25,000 of passive losses against non-passive income, subject to phase-out rules based on adjusted gross income [5].
Real Estate Professional Status
Real estate professionals can fully deduct rental real estate losses against other income, bypassing the passive activity loss limitations. To qualify, more than half of the taxpayer’s personal services must be performed in real property trades or businesses, and they must perform more than 750 hours of services in these activities during the tax year [5].
Relevant Tax Credits and Deductions
Several tax credits and deductions can benefit real estate investors:
- Low-Income Housing Tax Credit (LIHTC): This credit incentivizes the development of affordable rental housing for low-income tenants.
- Historic Rehabilitation Tax Credit: This credit provides a 20% credit for the rehabilitation of certified historic structures [4].
- Energy Efficiency Deductions: Deductions are available for energy-efficient commercial buildings under Section 179D.
Conclusion
Real estate investments offer numerous tax benefits that can significantly reduce an investor’s tax liability. By understanding and utilizing depreciation, mortgage interest deductions, 1031 exchanges, capital gains exclusions, and the impact of holding periods on tax rates, investors can optimize their tax positions. Additionally, navigating passive activity loss rules, achieving real estate professional status, and leveraging relevant tax credits and deductions can further enhance the tax efficiency of real estate investments.
Author of this article Jack Chaudhary specializes in Individual, Corporate Tax returns, Foreign Taxes, Expats, Non-resident Taxes, Payroll, Crypto and e-Commerce. With the Enrolled Agent credential, Jack represents taxpayers before the IRS and state taxing authorities. He zealously advocates for his clients to ensure the best results are achieved. Book an appointment here with him for a consultation call.
