Getting into the real estate investing business can be extremely lucrative. Most average people spend at least 25% of their take home pay on housing, so it only makes sense that the business can be profitable. Landlords, builders, flippers, wholesalers and agents all provide a valuable service that everyone needs.
Many people also like to talk about the tax benefits of getting into real estate as well. While there are indeed many advantages that the IRS provides for those working in real estate, there are many common misunderstandings about exactly what kind of advantages real estate investors actually have, and how exactly beneficial they can be.
Tax write-offs are commonly the first thing people think of when talking about tax advantages that real estate investors, or any business owner, can use to lower their tax burden. There does seem to be a common misconception about exactly what a write-off is, and how valuable they can be for the investor when filling out their return every year.
Write-offs allow a taxpayer to deduct certain expenses from their income before calculating their Adjusted Gross Income. While anything to lower your income, thus lowering your tax liability, seems like an advantage, in order to get the write-off you first have to spend the money on the expense.
For example, if you have to pay a plumber $500 to fix a leaky pipe in your rental property, you do get a $500 write-off, but it’s only a wash since you had to give the plumber your $500. It’s really not an advantage at all in many cases.
The advantage comes when buying things that you would have bought anyway, regardless of whether you are in the real estate business or not. There is, or course, language written into the code that prevents you from taking advantage of write-offs too much.
Let’s say you buy a pickup truck because you legitimately need it for your real estate business. You can deduct the cost of the truck from your taxes as a legitimate expense, and of course you are free to use the truck for your personal use as well. Some write-offs are indeed an advantage to the taxpayer, but in general they are only meant to make things fair, not truly advantageous to the investor or business owner.
Depreciation is another item on your tax return that most investors are allowed to take, and with some caveats, this one truly is an advantage to the real estate investor. Depreciation allows you to deduct the cost of your real estate property from your income every year.
If you purchase a house to rent to tenants, the IRS assumes that the useful life of that property is 27.5 years, although we know it will likely last much longer than that, essentially it will last in perpetuity. You are allowed to deduct roughly 3.6 of the purchase price from your income every year.
That could save thousands of dollars on taxes every year depending on the original purchase price of the property. Unlike write-offs, that is a real advantage, especially if the property was financed and the investor didn’t have to lay out the cash in the first place.
We did mention caveats, and there are indeed some. If the property is resold later, taxpayers are required to pay what is called a recapture tax on the depreciation dedication they previously used.
There is, however, a loophole around the recapture tax. Investors can use what is called a 1031 exchange, named after the tax code where it can be found, to avoid the recapture tax. If the proceeds from the sale of the property are used to purchase a more expensive investment property within six months of the closing of the sale of the original property, then the recapture tax can be avoided.
If an investor stays in the investment business forever, both recapture taxes as well as short and long term capital gains taxes can be avoided forever. That is an enormous advantage that only real estate investors have access to. Stock market investors do not have a way to do that. Tax advantaged retirement accounts such as 401ks or Roth IRAs can sometimes come close, but there are contribution limits and required minimum distributions which real estate investors do not have.
By staying in the real estate business and using the 1031 exchange, even relatively small real estate investors do enjoy a massive tax benefit that will reduce their tax burden by many tens of thousands of dollars over the course of their lives.
Becoming a Real Estate Professional
While tax write-offs offer at best a mediocre tax benefit to investors, and using the 1031 exchange offers a significant advantage to offset the recapture tax and capital gains taxes, becoming a Real Estate Professional in the eyes of the IRS has the best advantages.
It is fairly difficult to be able to use the Real Estate Professional status on your tax return. In order to claim it, you must spend 750 hours working in real estate, and also spend more time working in real estate than in any other area. In other words, someone dabbling in real estate part time cannot claim it.
The rules can get sticky and complex, but in a nutshell, those with the REP status can deduct passive losses from non-passive activities. It can be a significant advantage, especially among married couples where one spouse has a high income W2 job and the other spouse is working as a real estate investor.
Most investors should be consulting with a tax advisor to make sure they are taking advantage of all the laws and regulations available to them. It is important to keep accurate records so all of the write-offs can be properly documented. There is also some paperwork that must be filed in a timely manner to make sure that the 1031 exchanges will be allowed.
The PRE status is notoriously difficult to get, so if you are planning on claiming that on your tax return, it is particularly important to track and document the time that is spent on real estate activities.
Finding a trusted tax advisor to make sure your taxes are filed properly and you are getting all of the advantages you are entitled to is crucial for every real estate investor.