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There are many ways that you can defer or reduce your tax burden on your investment properties, and you’ll need to find the right strategy for you based on your current investments and income needs.
Investors acquire and own investment property because it can be a potential way to build long-term wealth, produce cash flow for investors, and create a profitable return when the asset is sold. However, these investments have their own unique set of challenges, one of which can be taxes.
Taxes can impact your investments both during the property’s holding period and following the sale. Cash flow and revenue from investment property ownership are taxed as regular income. In addition, profits from the sale of real estate are taxed at the federal capital gains rate and sometimes the state level as well.
However, there are ways to create a tax strategy that can help you keep more of your money in your pocket.
Leveraging tax incentives and deferments that are available in the tax code can keep more of your investment working for you, allowing you to better plan for your future. Using wealth management principles, investors can try to retain more of their principal investment by continuing to pursue passive income streams and cash flows while also using sophisticated tax strategies to help manage or, in some cases, defer taxes altogether.
There are many ways that you can defer or reduce your tax burden on your investment properties, and you’ll need to find the right strategy for you based on your current investments and income needs. Here are some of the most effective tax reduction strategies for investment property owners.
Leverage Deductions on Your Investment Properties
One of the best ways to keep more of your investment working for you is to leverage as many deductions on your investment properties as possible. Here are some of the tax deductions available:
Rental property expenses, including maintenance, advertising, and property management fees
Closing costs and associated legal fees
Any tools, home office expenses, or travel expenses related to real estate investing
Everyone’s tax situation is unique, and there may be other deductions you can take that are specific to your needs. Because tax codes change frequently and can be very complex, it’s best to consult with an accountant to help you figure out which deductions to use.
Consider working with an accountant that has special knowledge of investment properties, as they may have familiarity with deductions and tax strategies that you wouldn’t find on your own. Your accountant can help you keep track of these expenses throughout the year to make sure you aren’t missing any deduction opportunities.
Another way that you can potentially minimize your tax burden is to leverage depreciation on your properties. The IRS allows you to deduct depreciation on your properties as part of your taxes each year.
You can use this deduction for the length of your building’s lifespan as defined by the IRS. The IRS currently sets the lifespan of a residential building at 27.5 years and the life of a commercial building at 39 years.
For residential property, this means you can deduct 1/27.5 of the property’s value each year as part of your taxes, which comes out to approximately 3.6 percent. This can result in significant savings – for example, if your building is valued at $100,000, you can deduct $3,636 from your taxes each year.
It’s important to note that depreciation applies to many types of property and the IRS is fairly generous with allowing investors to use this deduction. In many cases, you can also use this deduction for capital improvements on your property. Say you spend $5,000 on a new furnace for your property. You will be able to deduct an additional $180 per year (3.6% of $5,000) for the lifespan of the furnace.
You’ll also want to keep in mind that the IRS charges depreciation recapture taxes if you sell the property and have been taking depreciation deductions. Because of this, consult with your tax professional if you are considering selling your investment property in the near future.
Increasing Cost Basis
Another strategy to consider is increasing your property’s cost basis. This strategy can be risky, but it can also be very effective when used correctly.
Your initial cost basis is the purchase price of the property. With this strategy, you would add to this cost basis by borrowing money for capital improvement projects, borrowing against the property for another purchase, or refinancing your mortgage.
There are a few ways that increasing your cost basis can benefit you from a tax perspective. First, you’ll save more with your yearly depreciation deduction in the short term. In the long term, you will also be able to save money on capital gains taxes.
For example, say you originally purchase a property for $450,000. While you own the property, you make $75,000 in improvements, which increases the cost basis to $525,000. A few years later, you sell the property for $600,000. In this case, you only have to pay taxes on a profit of $75,000 rather than $150,000 – significant savings in taxes.
Defer Taxes with a 1031 Exchange
With a 1031 exchange, you can defer the capital gains taxes on the sale of your investment property if you exchange the property for like-kind property of greater or equal value. There are specific timing rules and implications to keep in mind when it comes to executing a 1031 exchange, so it’s important to ensure that you can meet the identification timeline and exchange deadlines and that you are selling the property for a replacement investment of greater or equal value.
It’s not about the money you make, but it’s about the money you keep. By using these tax reduction strategies, you can potentially minimize the amount you pay on taxes for your investment properties each year, keeping your hard-earned money working harder for you.