April Fools! We actually don’t like paying taxes as much as the next person. That’s why we love real estate investing and all the wonderful tax benefits it provides us and our investing partners! It’s no wonder that some of the wealthiest people in the world are also some of the most tax efficient. That’s why many of the wealthiest American’s allocate some or all of their investment portfolios to real estate which has helped create their fortunes. I mean let’s be honest, if the IRS and the Federal Government are going to give landlords and real estate investors tax incentives to minimize your tax liability, why wouldn’t you invest in real estate? You work hard for your money so why not give as little to the Uncle Sam as possible? In this month’s Harbor Drive Investor, we’re going to cover just a few of the many tax benefits enjoyed by real estate investors everywhere!
But first… the legal stuff (per our attorney)
We are not accountants, attorney’s, or CFPs. This information is not conceived as an offer or solicitation to buy or sell securities. The information herein has been obtained from a variety of sources which are believed to be reliable but may be subject to change without notice. Investing in private securities incurs significant risk including loss of principal. Before considering any investment opportunity, every investor is urged to speak with their attorney, CPA or financial planner.
Now let’s get started!
THE WHOLE PROFIT PICTURE
When evaluating the feasibility and profitability of a real estate investment opportunity, many investors tend to focus on the usual measures of what makes a great deal. Things like Capitalization Rate (CAP Rate), Cash-on-Cash Return(CoC), Annualized Rate of Return (ARR), Internal Rate of Return (IRR) and Equity Multiple. But many investors fail to pay attention to the many tax saving benefits involved with a real estate investment. It’s not a bad thing to measure a deal’s profitability with the traditional financial measures without discussing tax, however it doesn’t really paint the whole picture of total deal returns and benefits to the investor. Below are just three of the most common tax saving benefits of investing in real estate that you can take advantage of.
1. REAL ESTATE DEPRECIATION
Real estate depreciation is one of the biggest benefits to investment property owners afforded by the IRS. It works on the basic idea that properties depreciate over time and therefore depreciation is a tax deduction for investors that covers the asset’s ‘wear and tear’ over time. At this point, you might be thinking to yourself, “how can a property decline while it’s value is appreciating over time”? The answer is, the IRS treats real property like any other type of capital asset. In their opinion, the real estate’s physical qualities diminish evenly over a period of time in the same way a delivery truck would diminish over time for a manufacturing company. The reality though is that with proper maintenance and a quality location, real estate generally tends to increase in value over time. This concept allows real estate investors to deduct depreciation expenses from their real estate income tax which allows investors to enjoy massive tax breaks against the profits of their investment.
HOW DOES THIS WORK?
According to the IRS, residential property (including apartment buildings) has a useable lifespan of 27.5 years. The IRS assumes a 39 year useable life for a commercial building (office building, industrial building, etc.). So to calculate depreciation on an apartment, you would take your building’s worth and divide that amount by 27.5. Example: We own an apartment building worth $5 million. That would allow us to use a depreciation expense of $181,818 per year against our rental profits ($5M value/27.5 years = $181,818 depreciation expense)! You can see why we are so excited about real estate as an wealth creating vehicle!
2. REAL ESTATE TAX DEDUCTIONS
Another great way investors’ of real estate can reduce their tax burden is by taking advantage of tax deductions. What are these you might ask? A tax deduction is an expense that can be written off a rental property investor’s taxable income. The law allows investors to deduct the expenses you incur to operate the investment including management expenses, maintenance and repairs costs, insurance premiums, utilities, marketing expenses, mortgage interest, etc. By taking these deductions to ‘write off’ against your cash flow and other profits, obviously you’re reducing your taxable income which reduces your tax liability.
3. PASSIVE INCOME TAX BENEFITS
A real estate professional is anyone who spends more than 500 hours on real estate annually. Real estate professionals get additional tax write offs in the course of conducting their active real estate business. But don’t worry! Even if you don’t qualify as a “real estate professional” in the eyes of the IRS, as a passive investor in a real estate deal, passive income tax benefits apply. If you are not a “real estate professional” (you spend less than 500 hours per year on real estate activities), then you will pay passive income tax instead of normal income taxes. And when the property appreciates in value, you’ll pay capital gains taxes. Generally speaking (depending on your income tax bracket), passive income and capital gains tax rates are lower than the federal income tax rates. This means that, if you are not a real estate professional (i.e. you invest passively in real estate deals), your real estate investment tax obligation will be much lower.
These are just a few of the many tax gifts given to real estate investors by the IRS that everyone should consider when on the fence about adding real estate to their investment portfolios. With these tax benefits, you can drastically reduce your tax burden.
Until next time,
WATCH: In the video below, HDH co-founder Rob Overstreet talks about the tax advantages of real estate investing and how they affect our investing partners’ returns.