Real Estate investing can be a lucrative business. If an investor makes wise decisions in terms of the type and condition of a property, the financial benefits can be multi-faceted. Not only is real estate investment a good source of income, it has tax benefits as well. These benefits can assist in taking advantage of tax strategies to avoid paying taxes on excessive income and maximizing your tax return.
- Use a 1031 Exchange
- Expenses for Tax Deductions
One of the most shrewd ways to defer capital gains is through the use of a 1031 Exchange. A 1031 exchange is merely using your current capital gains to reinvest in another property. There are three common qualifications:
- Like-kind exchange - The property you purchase must be the same type as the property you are exchanging. You cannot do a 1031 exchange by purchasing a commercial building after owning a residential property. The new property should be valued at the same or more than the previous property.
- Timing - You have 45 days to find a 1031 Exchange property. The closing must occur within 180 days after the sale of the original property.
- It is important to remember that the funds cannot simply be received by the investor but must be held in an escrow account specifically designated for the purchase of a replacement property. There should be an appointed intermediary and that person cannot be someone who you have worked with in the past 2 years.
The IRS dictates certain time periods for depreciating the value of a building. For example, a residential property can be depreciated over 27.5 years. This depreciation formula allows investors to claim a deduction to reduce tax liability on investment property. The IRS allows this tax benefit due to what they generally call 'wear and tear'. It creates what is often referred to as a 'phantom gain' because although the investor is actually receiving income from the rental of the property, the gain is significantly reduced or eliminated due to depreciation. This is an excellent tax strategy!
Although an investment property can provide income, it also costs money to upkeep. There are repairs and improvements, mortgage payments and interest, insurance premiums, and management expenses such as a cell phone, office, travel and more. Repairs such as new paint, fixing broken items or small updates such as new doorknobs or fixtures can be used as immediate tax deductions. Larger projects are considered improvements - a new roof, a/c or adding a room or deck are classified as improvements. Improvements are claimed under the depreciation portion of your property.