Tax-Saving Strategies for Real Estate Investors
1. Own Properties in a Self-Directed IRA
You’re probably familiar with IRAs and Roth IRAs as a tax-deferred way to invest for retirement. What you may not know is that you can set up your own self-directed IRA and use it to invest in real estate tax-free.
Be warned: This isn’t as simple as buying equities in a normal IRA.
First, you must hire a custodian or trust company to administer the self-directed IRA for you. They create the self-directed IRA, and you transfer money into it. You can then create a legal entity, such as an LLC, to buy and own investment properties. The self-directed IRA invests money into the legal entity as your chosen investment.
Where it gets complicated is if you want to finance the investment property rather than buy it in cash. Financing is allowed, but it comes with some important caveats. The loan must be “nonrecourse,” meaning the borrower can’t be individually liable, which many lenders don’t allow.
Also, only the nonfinanced portion of the purchase is sheltered from taxes by the IRA. And, of course, the normal IRA rules apply: You can’t withdraw money before age 59.5, and you must start withdrawing by age 72.
If you’re interested in investing in real estate through a self-directed IRA, start by researching custodians and speaking with them about the process and their fees. Check out Rocket Dollar, but be sure to do your homework and understand the process fully before committing to a custodian.
2. Hold Properties for More Than a Year
When you own something for less than a year and sell it for a profit, that profit is taxed at your normal income tax rate. That applies to flipping real estate, restoring and selling vintage cars, day trading, antique flipping — anything that involves buying low and selling high.
If you flip more than one or two properties in a year, you run the risk of the IRS classifying you as a self-employed “dealer” and subjecting your earnings to double FICA taxes (more on this shortly).
One option to avoid this is to own properties for longer than one year before selling. This negates the risk of being classified as a dealer and shifts your profits from being taxed as normal income to being taxed as capital gains. For most Americans, capital gains are taxed at 15% — significantly lower than most Americans’ normal income tax rates.
If you flip houses, consider renting them for a one-year lease term before selling them. You lower your tax rate, earn some cash flow, and may even benefit from appreciation and a higher sales price.
Here are some other tips to reduce your capital gains rate on real estate investments, along with additional details on who qualifies as a dealer.
3. Avoid Paying Double FICA Taxes
As mentioned above, if the IRS classifies you as a dealer rather than an investor, you’re considered self-employed and owe double FICA taxes.
FICA taxes are employment taxes designed to fund Social Security and Medicare. They’re split between employers and employees, with each party paying 7.65%. If you’re self-employed, you owe both, for a total of 15.3% in addition to your federal, state, and local income taxes.
Anyone who flips houses should form a strategy to avoid dealer classification by the IRS and thereby avoid this extra 15.3% tax. One way to avoid dealer status is to demonstrate “investment intent” for the profits of each sale.
In other words, build a case that you don’t sell properties as part of your regular business practice, but to generate capital for other investment projects. These other investment projects could include paying for improvements to another property or making a down payment on a long-term rental investment property.
Another strategy is to avoid doing business through a single-member LLC, which is typically disregarded for tax purposes. Instead, you can create a legal entity such as a partnership LLC or S-corp that changes how investors are taxed.
Talk to an accountant with plenty of experience working with real estate investors if you plan on flipping more than a couple of properties each year. Like many other elements of the tax code, this one has some gray areas, so you need to be able to make a persuasive case for nondealer status if the IRS challenges you.
4. Live in the Property for 2 Years
Ever thought about doing a live-in flip? You move in and, over time, make improvements and upgrades. If you live in the property for at least two years, the first $250,000 of capital gains are tax-free for singles. For married couples, the limit is a full $500,000.
Of course, you may not want to live in a constant work zone or move every two years, but if you love home improvement and tinkering around the house, it can be a fun way to earn money tax-free.
Consider it another option for house hacking to score free housing.
5. Defer Taxes With a 1031 Exchange
A 1031 exchange, named after Section 1031 of the tax code, allows property owners to defer paying taxes indefinitely by buying a similar property with their proceeds.
It works like this: Say you buy a property for $100,000, spend another $20,000 on improvements, and sell it for $150,000 for a $30,000 profit. You could pocket that $30,000 and blow it on meals out or a new car to show off how successful you are. You’d then pay income taxes on it, to say nothing of the sales taxes on your purchases.
Or you could invest it in another property and pay no taxes on it — at least for now.
Say you take that $30,000 and use it as a down payment on a new $200,000 property. In this next deal, you invest $50,000 in improvements and sell the property for a $60,000 profit. Now you have $60,000 in profit.
Again, you could spend this money, or you could reinvest it using another 1031 exchange. Perhaps this next time you buy a $400,000 property with it, a four-unit rental property that nets you $1,200 a month in cash flow.
If you sell that property, once again you would have to choose between paying taxes on the profits or doing another 1031 exchange. But no one says you have to sell; you could keep it forever and enjoy the extra rental income.
6. Do an Installment Sale
Say you sell a property for a $50,000 profit. For whatever reason, you don’t want to do a 1031 exchange to buy a new property right away. If you file your tax return with an extra $50,000 in taxable income in a single year, you can expect to pay some hefty taxes on it, which may well thrust you into a higher tax bracket.
Alternatively, you could spread the profit over many years by offering seller financing. In the year you sell the property, you only have to pay income taxes on whatever down payment and principal the buyer pays you.
Over time, they gradually pay down the balance they owe you, month by month, year by year. To make matters even better, you get to charge the buyer interest.
The risk, of course, is that they default and you have to foreclose on the property. Don’t enter an installment sale lightly, and make sure you thoroughly qualify the buyer.
One option is to start with a lease-purchase agreement, wherein the buyer starts as a renter with part of their rent going toward their down payment each month. At a certain down payment balance, you can then transfer the property to the tenant-buyer and sign a mortgage note and lien.
7. Maximize Your Deductions
One of the advantages of real estate investing is that every real expense, and some paper expenses, are tax-deductible.
You can deduct:
• Mortgage interest
• Property taxes
• Maintenance costs
• Property management fees
• Advertising expenses
• Software, tools, or other real estate support expenses
• Legal fees
• Closing costs such as title company and lender fees
• Home office expenses
• Travel and mileage expenses
• Pass-through deduction (more on that shortly)
• Depreciation (more on that shortly)
The best part? You can still take the standard deduction. Most of these don’t require you to itemize your deductions; they simply reduce the amount of total taxable income on your Schedule E or Schedule C.
Do your homework on exactly what tax deductions you can claim to minimize your tax bill, and as always, speak with an accountant to discuss any gray areas.
8. Take Advantage of the 20% Pass-Through Deduction
The Tax Cuts and Jobs Act of 2017 included an intriguing tax perk for small-business owners, including real estate investors.
On the simplest level, it allows small-business owners to deduct an extra 20% of their net business income. Of course, nothing is simple with the IRS. The allowed deduction is the lesser of:
1. Your “combined qualified business income” OR
2. 20% of the excess of taxable income over the sum of any net capital gain
What exactly is “combined qualified business income?” For some types of businesses, there are income limitations in place: $329,800 for married couples and $164,900 for single filers, in tax year 2021.
You can read the full IRS definition of “qualified business income” or save yourself the headache and talk to your accountant about it.
While it remains untested and not entirely clear from the IRS, with a sharp accountant, you should be able to deduct an extra 20% of your real estate investing business income from your taxable income.
9. Depreciate Your Properties
Another paper expense real estate investors can take advantage of is depreciation. The IRS sets the lifespan of a residential building at 27.5 years, so property owners can deduct 1/27.5 (about 3.636%) of their property’s building value each year for the first 27.5 years they own the property.
For example, say you buy a property for $150,000, with the land valued at $50,000 and the building valued at $100,000. Each year for the next 27.5 years, you can deduct $3,636 for depreciation: $100,000 ÷ 27.5 = $3,636.
You can also depreciate capital improvements to the property. For example, if you install a new roof for $8,000, that $8,000 can also be depreciated over 27.5 years.
That’s the good news. The bad news is that when you sell the property, you’ll owe taxes for “depreciation recapture” on all profits you had previously avoided paying taxes on through depreciation.
Of course, if you never sell, you never owe those taxes.
Fully depreciate items that have been replaced.
10. Realize Appreciation by Borrowing, Not Selling
The property you bought in the example above for $150,000 appreciates over time, and after a few years, you’ll have built some equity in it.
You could sell it and pay capital gains taxes on that equity. Or you could borrow against the property and not pay any taxes on your cash in hand. In fact, you’d get to deduct the borrowing costs — both the upfront closing costs and mortgage interest.
Over time, your tenants pay the loan off for you. You get to keep the property, which hopefully continues appreciating for you, and the rents rise with time, even as your mortgage payment remains fixed.
And when you pay off the loan in full, guess what? You can turn around and do it all over again, borrowing more cash against your property and letting your tenants pay that loan off too.
11. Die Owning Your Properties
If you die owning real estate, the original basis (acquisition cost) disappears, and your heirs pay no capital gains.
To continue the example above, your original basis for the property was $150,000. Let’s say that over 30 years, it appreciates to $900,000. If you sell the property, you can expect to owe taxes on your capital gain of $750,000.
Or you could keep pocketing the rent from the property every month and never sell it. If you want to pull out cash, you can borrow against it as outlined above, or you could leave it unencumbered and earn that much more cash flow from it.
When you die, the property passes to your heirs as part of your estate. The cost basis “steps up” to its current value of $900,000, so they don’t owe capital gains taxes if they sell it immediately.
They may owe estate taxes on it, but only if you died wealthy; the first $11.7 million of your estate is tax-free in tax year 2021. Otherwise, they get to sell the property and keep the proceeds, tax-free.
If you want to win at the game of wealth, you need to know the rules. And nowhere is that clearer than when learning how to slash your income taxes.
Learn how to capitalize on the tax advantages granted to real estate owners. Throughout your life, they can save you hundreds of thousands of dollars or more and help you put more of your money toward building wealth.
And if you hold onto your properties until you die, not only do you avoid paying taxes on the gains and depreciation recapture, but your children inherit them tax-free. That’s a winning legacy to leave behind, by any standard.
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