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The Ultimate Tax Benefits of Real Estate Investing
Last Updated: August 21, 2o24
Steve Nabity
August 21, 2024
The Ultimate Tax Benefits of Real Estate Investing
Once there was a baker who included things like cat food, bird seed, and a dog bed as business expenses in his tax return. He reasoned that the cat food would keep mice away from the storage area, the bird seed would attract birds that eat the crumbs lying on the ground, and the dog would keep a watch at night. The baker claimed that taxes were like baking a cake – you need the right ingredients and a little creativity.
While we don’t advocate being creative with taxes like the baker was trying to be, we certainly would want business owners and entrepreneurs to be smart with their taxes and investments. After all, growing your hard-earned wealth while saving on taxes would be like having your cake and eating it too.
In this article, we will talk about unlocking wealth by maximizing tax benefits through real estate investment. We will touch upon the various benefits of real estate investing and taxes. Lastly, we will also cover how to defer capital gains tax to grow your portfolio continually.
Real Estate Investing and Taxes
Real estate is, in some ways, a unique asset class. It offers cash flow, capital appreciation, and tax benefits. These are some of the key reasons why investors prefer to invest in real estate. From a strategic point of view, business owners and entrepreneurs can reduce their tax burdens when the economic environment is challenging. Tax benefits of investing in real estate can help preserve valuable cash flow while strengthening financial resilience. Certain expenses associated with real estate can be claimed as deductions that reduce taxable income and lower the overall tax liability.
Skyline Point Capital places great emphasis on taxes and real estate investing when identifying opportunities. We invested in a multifamily property in Nashville called Keystone Farms. It had 90 units and the plan was to add value to the existing property through upgrades. The deal was financed with a mortgage. So, there was an interest expense throughout the hold period which was tax deductible. Additionally, the property had a depreciation expense associated with it which was also tax deductible. These expenses reduced the taxable income and the overall tax liability. Some of our investors utilized the 1031 exchange to save on capital gains tax earned from a previous transaction. They used the proceeds from the sale of that previous investment to fund the Keystone Farms deal, deferring the payment of capital gains taxes.
There were other deals too that allowed investors to take advantage of other such tax benefits. Sometimes, investing in an economically depressed area or “an opportunity zone” or investing in affordable housing that has some kind of associated tax benefit, can result in substantial tax savings for our investors.
How you can save tax by investing in real estate?
Wealthy individuals like entrepreneurs and business owners are among the most taxed in the country. Just have a look at the graphic below to see what we mean.
Therefore, it becomes important, especially for such individuals and families, to understand how real estate can provide an advantage to a portfolio of investments from a tax perspective. At a broader strategic level, one has to think about the impact of an investment decision on the overall portfolio and the tax liability at a portfolio level
Below are the major tax benefits that real estate investments can potentially offer:
Mortgage Interest Deduction
Any loan used to acquire, develop, or improve real estate properties tends to lead to interest expense. This expense is tax deductible and can be a substantial portion of the overall operating expenses. As it can be viewed as a business expense, interest deduction can bring down the taxable income materially. As the saying goes, “Leverage is not just about multiplying returns; it’s about harnessing the power of tax deductions to amplify your financial gains”.
Property Tax Deduction
Taxes are a large chunk of the fixed expenses for a property. Counties and cities with higher taxes make this statistic even more prominent. Depending on local laws, taxes paid on rental properties usually tend to be treated as a deductible expense. In a world where so much is uncertain other than death and taxes, such deductions are valuable as they can bring down the taxable income
Depreciation
Depreciation allows you to deduct the cost of a property, spread out over some predefined period, from your income. It is an accounting expense without you having to actually spend any money. Depreciation accounts for the gradual wear and tear on the property. Typically, residential properties are considered to have a life of 27.5 years while commercial properties have a life of 39 years. So, investors can spread out the total cost of the property over that time as depreciation and treat every year’s depreciation as an expense. The net effect is a lower tax liability.
There is something known as accelerated depreciation where a larger portion of the cost can be deducted in the initial years of an investment. This can also be helpful in certain situations. Consult a tax professional to find out more.
Repairs and Maintenance Deductions
Whether fixing broken windows or plugging leaky faucets, repairs and maintenance is an ongoing activity at any property. There can be different types of wear and tear over time. Therefore, real estate requires regular expenditure to ensure it is kept in good condition so that new tenants are attracted to the property. Such repairs and maintenance expenses are tax deductible.
Do note that capital expenses that improve the property and add value are not repairs and maintenance. Rather, such expenses are capitalized and then depreciated.
Operational Expenses
In addition to depreciation and maintenance expenses, several other operational expenses can be deducted from the property’s income. These include property management expenses, insurance premiums, legal and professional fees, advertising costs, and certain utility expenses paid by the owner. All such expenses can further reduce the taxable income and reduce the overall tax liability.
Other Benefits
Certain travel expenses to manage the property can be deducted for tax purposes. Investing in opportunity zones (usually distressed locations), affordable housing, and properties with housing tax credits can also lead to a range of tax benefits. At Skyline Point Capital, we often see opportunities to invest in such properties.
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Can you avoid capital gains tax by investing in real estate?
Are you wondering how to pay no taxes with real estate investing? If you are, then stop right there because we are not discussing a tax-free investment or any such opportunities. We don’t want you to misunderstand avoiding tax immediately with paying no tax at all ever.
Instead, what we want to discuss is the 1031 section of the Internal Revenue Code. It allows an investor to re-invest the proceeds from the sale of one investment into another similar property and thereby not pay a tax on the capital gains generated from the sold investment. In effect, the 1031 exchange allows you to “kick the can” further down the road as you can defer paying capital gains tax.
This can be an interesting means to diversify a portfolio. Someone invested in a property wanting to diversify or upgrade their investment can do so via the 1031 exchange without incurring an immediate tax liability from capital gains.
There is another benefit called Primary Residence Exclusion that may not be applicable to real estate investors but is great for homeowners. If you sell your primary residence (where you have lived for at least 2 of the last 5 years), then you can exclude up to $250,000 of capital gains when filing taxes.
We discussed investing in opportunity zones for tax benefits. Such benefits can be deferral of capital gains or an exclusion of additional capital gains beyond a specific number of years. The government incentivizes such investments to stimulate economic growth in areas where it is needed the most.
While we have highlighted the various ways you can reduce or defer capital gains tax arising from real estate, we believe speaking to a tax professional is the best way to understand the current laws and complexities associated with capital gains taxation.
How SPC Can Help You Begin in Real Estate Investing
Now that you have a broad idea of how real estate investing can lead to tax savings, you may be thinking about how you can get started. Reaching out to Skyline Point Capital could be the first step. We look forward to discussing not just real estate, but also taxation and other aspects of investing in real estate. While we always recommend that you consult a tax professional, Skyline Point Capital can provide basic guidance on tax incentives for real estate investing.
We suggest that you download one of our free guides on finding the right deal and mastering the key aspects of real estate investing. Skyline Point Capital has been working with business owners, entrepreneurs, and individual investors for several years. We understand the specific issues faced by such investors be it taxation, financial planning, or other legal aspects.
Our dedicated team of experts takes a holistic view of all aspects of a deal that optimizes financial performance and helps our investors achieve their financial goals. Having built the experience of making tax-efficient investments in the past, we are ideally positioned to help business owners and entrepreneurs optimize their portfolios from a returns as well as taxation viewpoint.
We encourage you to request an invitation to join our exclusive community of business owners and entrepreneurs and get access to institutional-grade private real estate investing opportunities.
Learn more about Skyline Point Capital here.
Conclusion
We hope that you found this article on the ultimate tax benefits of real estate investing useful. By now, you will have a good idea of the various ways in which taxes can be optimized by investing in real estate. This asset class also has the potential to offer stable returns in the process and contribute positively to any portfolio.
In this article, we covered the various deductions that are associated with real estate investments. We also discussed how capital gains taxes can be deferred and, in some cases, reduced. We gave a real-life example of a deal we closed that offered tax benefits to our investors.
Take advantage of some free resources that Skyline Point Capital offers and download The 5 Keys to Mastering Real Estate Investing to get started with real estate investing. In addition to the guide, sign up for our investors club community and learn about tax-saving real estate investment opportunities currently on the market.
We wish you all the luck and success for your future investments!
