One reason that real estate investing is such a good deal is that the IRS has rules that create great opportunities for those holding property. Although everyone knows that you can write off your mortgage interest, here are four additional strategies you may not know that could help you save a bundle. Of course, we recommend that you always speak to a tax accountant before using any of these strategies to be sure they are right for your situation.
Tax Strategy #1: Depreciation of Rental Property
According to the IRS, renting property is a business expense that depreciates over time. This means that you can deduct depreciation losses. For a single-family home and duplexes, this depreciation lasts for 27.5 years. Let’s see how this works:
- You have a duplex worth $400,000 with a loan of $320,000.
- The property produces a cash flow of $24,000. This is the amount of money the property makes after you pay the mortgage, taxes, insurance, and other expenses.
- The depreciation deduction for the first five years is about $32,000
- This will give you a tax loss of $8,000 a year for those five years.
This tax loss can offset other income you have, reducing your tax liability.
However, investors understand that this depreciation is not real. Although the IRS gives landlords a depreciation for their him, the home will actually increase in value. Therefore, you get to double-dip by saving money for a loss while actually making a profit at sale for the appreciation value.
Tax Strategy #2: Safe Harbor for Small Tax Payers
Landlords have always had to figure out the difference between a repair and an improvement because repairs are deducted in the year it occurred, and improvements have to depreciate over several years. In 2014, the IRS established a safe harbor rule that now allows landlords to deduct expenses that used to be considered improvements. At the beginning of 2016, rental property expenses were expanded from $500 to $2500 each incident.
However, there are ways to increase the $2500 each incident by breaking down the expenses into different categories.
For instance, a $4500 new roof would be more than the $2500 incident for safe harbor. That would mean you would have to take depreciation of the new roof t $180 over 25 years. To get the full deduction in one year, you could, instead, break this down into pieces. One would be the payment of for materials of $2300, and one would be the payment for labor at $2200. In this way, you can count both as safe harbor incidents.
Keep in mind that this safe harbor only works for properties that were rentals. You cannot have lived in the property for more than 14 days during the year. Always check with a tax accountant that understands real estate investments.
Tax Strategy #3: Using the 1031 Exchange
The 1031 exchange can help you avoid paying taxes on profits. This rule allows you to move the money you made from one sale into a new investment of equal or greater value without having to pay capital gains taxes. The 1031 gives you 90 days to find another property and 180 more days to close on that property.
Another great implication of using the 1031 exchange is that your heirs will have a lower tax basis than the actual value. Tax law states that any gain in investments disappears at your death. This means that even if the property had tripled in value, your heirs would not have to pay capital gains taxes in addition to estate or inheritance taxes.
Tax Strategy #4: Using an HELOC to Free Up Capital
If you want to use the equity in a property without selling it, consider taking out a home equity line of credit. The IRS sees this as a debt, not as income. Then, you can use this money to do what you want without paying any taxes. Keep in mind, however, that you will be paying interest, so it would be wise to see whether paying taxes or the interest is the better deal.
When you add real estate to your portfolio of investments, you have the ability to take tax deductions not offered by other investment vehicles. Keeping good records and talking with a tax adviser can help you offset other income, effectively decreasing your overall tax rate.