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Tax Benefits of Investing in Real Estate

Lots of people love the idea of investing in real estate. There’s something to be said for being able to drive by or walk through your investment.


In addition to the tangibility of real estate as an investment, it has had historically strong investment returns (with the notable exception of the 2008 financial crisis), and there are many tax benefits - just a couple of which I'll outline below.


When you buy an investment property, you can deduct expenses related to the production of income on the property, just like you would be able to with any other business venture, but there are a couple of additional tax benefits unique to real estate investing to help investors save money on taxes while they operate a property and even upon selling a property.


The Benefit of Depreciation

Depreciation is a deduction based on the purchase price of a property. You can’t depreciate land, so only the portion of the price attributable to the building can be taken as a deduction. The IRS also stipulates the timeframe for depreciation (27.5 years for residential buildings and 39 years for commercial buildings).


Depreciation is a non-cash flow expense, deferring taxes on income without a corresponding cash outflow.


Here’s an example:

Sue bought a residential rental property for $200,000 and started renting it out on January 1, 2023. The purchase price attributable to the land is $50,000, so the other $150,000 can be depreciated over 27.5 years.


In 2023, Sue makes $18,000 in rent and has expenses of $12,000. Without depreciation, her taxable income would be $6,000. But since we can take an expense for depreciation, we can deduct an additional $5,455 ($150,000 divided by 27.5). This means that even though Sue had $6,000 of cash flow in 2023, she only has to pay tax on $545 of it. 


If Sue’s tax rate is 32%, the depreciation deduction saves her $1,746 in taxes for tax year 2023!


It’s important to know that if Sue ever sells her property (without using one of the strategies laid out below), she would owe tax on the amount of depreciation taken over the life of the property in addition to price appreciation over her hold period.


Selling Your Investment Property

Generally, if you sell something for more than your basis (typically what you bought it for), you have to pay tax on that gain. But real estate offers the ability to defer that gain through what is called a 1031 exchange (also known as a “like-kind exchange”).


A 1031 exchange allows investors to sell one property and replace it with another without paying tax on the gains. There are a lot of rules involved, so always engage a tax professional if you’re interested in this strategy. 


When doing a 1031 exchange, you can’t take any of the cash into your possession, so you have to hire a qualified intermediary. Any cash you do take is taxable, and there are time limits to adhere to for when the next property has to be identified and purchased.


Most real estate investors are familiar with the idea of a 1031 exchange, but many don’t realize that you don’t necessarily have to find and manage the next property yourself. Enter: the Delaware Statutory Trust (DST).


The DST is an investment product that acts as the replacement property for real estate investors selling a property. The DST itself pools capital from a number of investors, then invests in one or multiple properties. They can be a great tool for people who want to be done with being a landlord, but don’t want to pay tax on the sale of their properties.


Conclusion

If you’re going to invest in real estate, you should understand how to take advantage of the tax benefits available to you. Curious whether investing in real estate is right for your situation? Wondering whether any of these strategies would be good for you to think about? Feel free to reach out via my contact page with questions, or book a consultation.

 

As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner in Eau Claire, Wisconsin, and I work virtually with people across the US. Check out my website to see what it's like to work with me and reach out if you have any questions.


If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.


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