Many investors are becoming aware of the various advantages that come with real estate investments. Previously, we’ve discussed how real estate can help diversify your investment portfolio, but the benefits don’t stop there.

You can also use several strategies to minimize the taxes on your real estate investments, meaning you can maximize the returns!

Our post today will discuss a few ways to protect your real estate income from being subjected to taxes.

1031 EXCHANGES

Investors can use 1031 exchanges to purchase a second property without paying taxes on the sale of the first property.

1031 exchanges take advantage of Section 1031 in the IRS’ Tax Code: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Basically, this allows investors to sell a property and use that money to buy a new one… tax-free. You get to carry the full investment forward into another property without having to pay the capital gains tax.

Let’s see how this works in a simple example:

Assume you purchased a house several years ago for $100,000. Thanks to a growing market, the house is worth $200,000 today and you decide it’s a good time to sell.

Using a long-term capital gains tax rate of 15%, that puts the IRS bill at $15,000.

But we can bypass that tax with the 1031 exchange.

Instead of paying the taxes, you use the money from selling the house on your next real estate investment, like a 20% down payment on a $1,000,000 property.

The 1031 exchange allows you to afford an additional $75,000 worth of property in this scenario. ($75,000 x 20% down payment = $15,000 saved taxes)

Now imagine repeating that process on each real estate investment and you can see the potential benefit for investors over time.

DEPRECIATION EXPENSES

Depreciation simply represents the decline in value over time. Taking a real estate example, the IRS says that residential real estate value declines over 27.5 years, while commercial real estate depreciates over 39 years.

This means, in the eyes of the IRS, your property is losing value consistently over the years and decades. The good news for you as the investor: you can write off the depreciation as an expense.

Investors often take advantage of this cost to reduce the taxes they pay on real estate investments. The strategy is effective at reducing the taxable income from investment properties.

Let’s draw up a quick example:

Since depreciation only applies to the building, not the land, let’s assume you bought a house and the home itself is valued at $100,000.

According to the IRS, the house depreciates over 27.5 years, so the annual depreciation expense would be:

$100,000 / 27.5 = $3,636

Now let’s look at our income side of the equation. Let’s say you take home $300 each month in rental income from the house. Your annual income would be:

$300 x 12 months = $3,600

Here is where depreciation works in your favor when it comes to tax time. Even though you made money from your rental property, once you deduct the $3,636 depreciation expense from your $3,600 income, you actually show a loss of $36 for the year.

This is commonly referred to as a ‘paper loss’ because on paper the IRS sees that you lost money, but in reality you made $3,600 throughout the year.

The flip side to this strategy is the IRS’ recapture of depreciation. This occurs only when you decide to sell, and the tax rate is currently 25%.

So in our prior example, if you sold the house after 10 years, you would have accumulated $36,360 of depreciation expenses. Pending other factors, that depreciation might be taxed at the 25% rate after the property is sold.

Depreciation can be a strong tool to minimize taxes, just make sure you have all future tax obligations in mind when deciding which strategy is best for you.

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SELF-DIRECTED IRA REAL ESTATE INVESTING

If you’re looking to invest in real estate through your retirement account, consider setting up a self-directed IRA. Self-directed IRAs allow for investments outside the traditional scope, like real estate or precious metals.

This gives you the opportunity to buy and manage real estate properties using your IRA funds. Investors are increasingly taking advantage of this opportunity to purchase rental properties.

The benefits are the same as any other investment in your retirement account; taxes are deferred until you pull your funds out of the account (or without tax penalty if you wait until age 59 ½).

Investors are able to manage their properties — buy, sell, flip — and leverage the IRA’s tax shield. This means you can defer taxes as funds flow from one project to the next.

While a self-directed IRA can be a savvy way to minimize taxes on your real estate investments, there are several limitations. Investors should do their diligence if considering this route and make sure it’s the right strategy for them.

For example, no personal transactions are allowed. If you conduct a real estate transaction with a family member, that creates a taxable event. The same goes for a primary or secondary residence. Those types of real estate deals fall outside of the IRA’s tax shield.

But if you’re using real estate strictly as an investment vehicle, doing so through a self-directed IRA can give you more control over your investments, and provide similar tax benefits as other investments in your retirement account.

KEY TAKEAWAYS

Real estate provides several benefits for investors. We’ve previously discussed the diversification advantages with real estate, but there’s potential tax benefits as well.

Several strategies are available for investors to minimize the tax expense on their real estate investments. Anyone currently invested in real estate, or considering real estate investments, should familiarize themselves with the various tax advantages and determine which approach suits them best.

Choosing the appropriate strategy related to taxes can dramatically impact your success in the real estate markets and boost the returns you see throughout your investment career.