8 tax advantages of real estate

If you talk with real estate investors, you will often hear about the tax advantages of real estate investing. People will often talk about them as a silver bullet that makes real estate investing more lucrative than other investments. But it isn’t always clear what tax advantages they are talking about. And, in some cases, they ignore the complexities and potential downsides of these strategies, which can impact the overall returns that you will see.

In this article, I provide a brief summary of several of the most common strategies for eliminating or, more commonly, deferring taxes based on real estate investing. As always, this is not tax, legal, or financial advice. This is strictly informational, giving you something to think about. If you are interested in one of these strategies, talk to your professional team to get advice relevant to your situation.

The home ownership exclusion [1], the most well known real estate tax benefit, is not for real estate investing. If you own your primary residence, and have lived there at least 2 out of the last 5 years, the first $250k ($500k if you are married) you make on the sale of the property is exempt from taxes. This is one of the few ways to actually eliminate taxes, and is a great benefit of home ownership that can put $100k in your pocket. Many people are aware of this benefit, but don’t pay much attention to it until after they have sold the property. While taxes should not be the driving factor for your life, it is worth considering whether or not to move once you are approaching that amount of equity, so that you can reset your basis and keep from paying taxes as prices continue to rise over the long term. It is also worth considering whether to use the exclusion if you have converted your old residence into a rental a couple of years ago or have a rental that has appreciated a lot and you wouldn’t mind living in.
The reduced tax rate of long-term capital gains [2] is a related benefit as most of the taxes owed on real estate result from the sale of the property. Long term capital gains are typically taxed at 15%-20%, which is lower rate than the normal income tax rates. This difference can result in a savings of 5% to 17% on your federal taxes, depending on your income level (plus savings at the state level as well). It is important to realize that this tax treatment doesn’t apply to certain types of real estate investments, such as a house flipping, where it is an active business and the property is usually held for less than a year, or investments in notes, where what you own is a mortgage not the underlying property.
Deprecation [3] is the tax benefit that real estate investors think about most. Depreciation is an exciting tax deduction because it gives you a paper loss – you get to write it off like an expense, but you don’t actually have to pay it. The basis that you use for depreciation is usually the value you paid for the property minus the value of the underlying land. Once you know your basis, there are a couple of ways to calculate your deprecation expense. The easiest (but not best) way to do it is to write off a fixed percentage of the basis each year – this “straight line deprecation” is easy to calculate, but usually results in you not getting as much value as possible out of the benefit. The more complicated approach is to have a cost segregation study [4] performed. This breaks out all of the components of the property (e.g. landscaping, electrical, plumbing, carpet, counters, appliances) into their appropriate tax categories and allows you to depreciate each of them according to their expected useful life. This results in the ability to accelerate your deprecation schedule, getting you more deductions faster. In previous years, when 100% bonus depreciation was allowed, it was possible to deduct the entire value of 5, 10, and 15 year property in a single year. For most investors, a cost segregation will generate more deductions than you can take in a year, which allows you to carry forward those losses into future years. One of the down sides of depreciation is that if you partially depreciate an asset, then sell it for more than its depreciated value, you end up paying tax on the depreciation (i.e. depreciation recapture). The good news is that this tax is at a lower rate than your normal tax rate, so you still end up winning (both on the difference in taxes and from the “time value of money” [5]). And, if you have fully depreciated the property identified in the cost seg study (e.g. if you sell in year 6, you have fully depreciated all of the 5 year property), the gains are reflected as long-term capital gains instead.
All business expenses can be written off against business income, reducing the amount that is taxed (taxes on any business are against the profit the business makes, not gross income). For most expenses, this is not really a benefit, since you incur the expense in order to run the business. For example, you pay property taxes and insurance on your rental so that isn’t part of the profit. However, there are cases where you can be more strategic. For example, if you live a long distance from your property, you are able to write off 1-2 trips per year to visit your property, do a site inspection, meet with your local contractors, etc. If your property is located in a place you want to visit, say near family or in a popular vacation location, you can write off your trip while both doing business and enjoying some personal time. In addition, depending on your business, you may be able to write off expenses that you already incur, such as your cell phone bill, home office, etc. There are rules that need to be followed, but when applicable, you can make an expense you would otherwise incur tax deductible and thus reduce your overall tax burden.
The 1031 exchange [6] is a way to defer taxes on an investment property that you want to sell by rolling the proceeds into another investment property. There are a lot of rules that need to be followed exactly in order to avoid paying taxes, but if you follow them, the effect is that you just converted your old property into your new one and have no taxes to pay. One of the downsides of this approach is that your basis in the old property carries forward into the new one, which affects the depreciation you can take on the new property. Another is that the tight timelines lead some people to make poor investment decisions simply to avoid the tax. It is important to realize that this is a deferral strategy, it doesn’t eliminate taxes completely, it just delays when you need to pay them. If you eventually sell the new property and don’t reinvest it, you will end up paying taxes then. The only exception is when you die, your heirs receive a step up in basis to the market value of the property on the day you die.
Opportunity zone funds [7] are a relatively new tax benefit arising from the Tax Cuts and Jobs Act of 2017. There are two reasons these funds became very popular. The first was that you could defer capital gains taxes due until either the sale of the property or Dec 31, 2026. This meant that you could sell a highly appreciate asset, such as a stock, and not pay taxes for up to 10 years. The value of this benefit obviously decreases the closer we get to Dec 2026. The other benefit is that, depending on how long you hold the property, your basis will adjust to eliminate between 10% to 100% of the capital gains taxes that would normally be due based on the appreciation of the property. This is a huge advantage and can significantly impact the returns seen by the investors. There are a lot of rules that need to be followed and the opportunity zones are not necessarily in the locations where you will want to invest, so you need to be aware of the risks as well as the potential benefits when evaluating investments in these funds. If the investment makes sense without the benefits of being in an opportunity zone, then the additional tax savings can be a nice bonus.
Short term rental losses can offset active income [8]. If you have a rental that has an average stay of 7 days or less, and you provide substantial services (like room cleanings), then the IRS considers you to be involved in a business – like a hotel – not a rental. This means that if you materially participate in the rental, then you can take any losses from the business, such as depreciation, and deduct it against other active income you have, such as wages from a job. With the rise of AirBnB coinciding with bonus depreciation, this has become a popular deduction for high income earners who can use cost segregations to generate large losses from depreciation in the first year of owning and operating the rental. Once the depreciation has been applied to generate a loss in the first year, the rental can be converted to a long-term rental or a property manager can be used to offload most of the work for future years. The challenges with this approach are making sure that you have established the property as a short term rental (an unexpected 2,3, or 4 week rental could increase cash flow but mess up this deduction) and can meeting the material participation test in a way you can demonstrate to the IRS if audited.
Real Estate Professional Status (REPS) [9] is one of the most coveted tax deductions, but also effectively impossible for someone working a full time job to obtain. If you qualify, you are able to take the deductions that would normally be considered passive losses and deduct them against your active income. This is particularly helpful when you are married, where one spouse can have a high income job and the other can qualify for REPS, since the passive losses (obtained through depreciation) can reduce the taxes due from the salary. In order to qualify, you need to spend more than half your time, and at least 750 hours in the business of real estate, and materially participate in your rental activities. For those working a full time job, that is effectively impossible. However, effectively using this status is how many real estate professionals end up reducing their tax burden to almost nothing.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

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This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.