The Many Tax Benefits for Real Estate Investors

Real estate has been white hot over the last few years, and many people have made money investing in this sector of the market. But how and why? With the market starting to cool and return to normal levels of appreciation, there are still deals to be found that, for the diversified investor, would make a great addition to any long-term portfolio. But why should an investor with no experience in real estate consider this industry for a large portion of their portfolio? The answer is complicated but can be distilled down to one word: Taxes.

Real estate is one of the few sectors of the American economic machine that Congress has codified its public policy of encouraging investment in this sector. From 1031 Exchanges to Cost segregation studies, it is clear Congress believes the private sector is better equipped to help house America’s population than the Government, so Congress, in turn, will help and encourage investors to do just that. But how do they encourage those investors? Through rewarding investors with tax benefits that make substantial increases to bottom lines and deferring to offsetting taxes through heavy deductions. 

Here are the highlights of tax benefits for real estate investors:

Real estate and taxes

Real estate is one of the few asset classes with multiple tax benefits that are underappreciated by financial advisors. Why? It could be that financial advisors don’t make a commission on them or that you actually do not need a financial advisor to get into real estate. Not to diminish the role of your advisor, but you do not need a financial advisor to understand these tax benefits of real estate.

1. Real Estate is depreciable. Yes, you can depreciate residential real estate over 27.5 years and commercial real estate over 39 years. 26 USC Section 179 allows for the depreciation of real estate over the life of the asset class, and in the case of real estate, you can take a $500,000 residential property and depreciate it over 27.5 years. This means that you can deduct $18,181.81 each year in depreciation.
2. Bonus depreciation. Section 168(k) of the Tax Code allows for Bonus Depreciation. This is tax talk for saying that the Tax Code will allow investors to take additional depreciation on an asset used for business purposes rather than limit the depreciation to what is set for on the useful life tables. The benefit of bonus depreciation is a larger deduction in the year it is taken; this, in turn, leads to less tax owed because of the correlating income offset from this deduction.
3. Real estate capital gains can be deferred. Under Section 1031 of the Tax Code, if you hold a property for the requisite holding period, which is not defined in the Tax Code, you can sell that property via a like-kind-exchange using an intermediary to hold the funds while you identify a new property or properties within 45 days and close on those identified targets within 180 days. This allows you to defer capital gains taxation and forebear depreciation recapture while buying larger and, hopefully, better cash-flowing real estate assets. Thus, this tax mechanism allows the investor to take their profits and leverage those into more assets, thereby growing the real estate portfolio in a tax-efficient manner.
4. Cost segregation. Depreciation of the real property can be accelerated by using cost segregation studies to break the assets into various parts that fall under separate classes to allow the individual components to be depreciated over 5, 7 or 15 years. This allows the property’s components to be utilized in a tax-efficient manner instead of using the 27.5 or 39-year class life of the entire asset. A net result of a cost segregation study is to accelerate the depreciation to allow for more Section 179 depreciation to be taken earlier in the asset’s life.
5. Business deductions. Section 162 of the Tax Code allows for deductions of business expenses in furtherance of the business in which those expenses are made. For example, should an investor need to purchase a subscription to a Multiple Listing Service, purchase an App for his or her phone to track mileage, buy a computer, printer, desk, or chair, pay a portion of their mortgage and utilities for their home office (Section 280A), purchase a vehicle to travel to their properties, purchase a truck for haul refrigerators, ovens, supplies, or even to check on their properties, these are all expenses of the investor that are deductible.
6. Business interest expense. Section 163 of the Tax Code allows for business interest expenses to be deducted. What does this mean? Here is what the Code says:  There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. Given this allowance of interest as a deduction, the interest on loans for the purchase of real estate is deductible beyond the current $10,000 limitation on mortgage interest cap for personal residences. This is not without limitation, and investors should consult their accountants about those limitations, currently set forth in Section 163 (j).

While more tax nuances can be discussed, these are the tax benefits that high-net-worth individuals should look into. Additionally, by working with a sophisticated lawyer who understands the needs of the individual and their goals, tax losses can be carried forward to future years. 

Real estate and passive income

Whether using long-term residential real estate, commercial storage units, short-term residential real estate or apartment syndication deals, real estate allows the owner and investor to take a passive role in the management of their real estate by utilizing property managers. 

The use of property managers provides the investor with the peace of mind that their investment is in good hands for day-to-day matters such as maintenance and that their tenants are safe in the knowledge that they have someone to turn to in the event a need arises. Moreover, for the cost of the monthly management fee, ranging from 3-40% of the monthly gross rents, higher percentages are usually found with short-term rental management and lower fees with long-term residential property management, so there is no need to worry about late-night phone calls about a clogged toilet. 

Property managers will also ensure the yard is maintained, the utilities are being paid, the tenants are of the caliber desired, and any marketing efforts to rent the properties are being undertaken to ensure maximum rental potential. At the end of each month, a revenue statement is generated by the property manager, and a check or direct deposit is provided into the bank account the investor designates. A true passive investment. Section 469 of the Tax Code discusses passive activities. It is of note that Short Term Rentals are unusual given the 7-day safe harbor exception for rental activities. Again, this is an area that your accountant and lawyer can help you navigate to achieve optimal tax treatment.

Asset appreciation and leverage

While your tenant is paying the rent each month or, in the case of short-term rentals, multiple tenants, the note held by the investor is being paid down. Historically, real estate appreciates in value, so the asset is increasing in value. As the asset increases in value and the debt is being paid down, the investor receives the benefit of equity growth. It is with that equity growth that the value of real estate cannot be overstated. 

By tapping into the equity growth through a refinance or an equity line of credit, the investor can leverage that internal equity to purchase additional real estate. The additional real estate purchases allow the investor to generate more cash flow and more tax benefits. Regardless of the asset type, short-term, long-term or commercial real estate, the benefits to the investor are tangible in the form of tax deductions while maintaining monthly cash-positive receipts.  

Taxes are a very real and very certain part of the investor’s concern as they head towards their goals for retirement or even financial freedom to pursue other endeavors. The Code sections discussed above are simply the tip of the iceberg for real estate investors. Talk to your team of professionals about real estate.

This article was originally published on The Chicago Journal.