Tax Strategies You Need as a Real Estate Investor
With growing your real estate business comes more tax questions and confusing terminology, but it doesn’t have to be complicated! We’re sharing hot tax tips to make sure you are using a forward-thinking tax strategy to start the new year off right and minimize your tax burden. We always recommend consulting with a tax professional or financial advisor for personalized advice tailored to your real estate investments, but keeping these tax strategies in mind will help in the long-run.
Here are some common tax strategies to keep in mind as your real estate portfolio grows:
1031 Exchange
Die (morbid, but real life) while owning your properties
Sell your primary residence of 2 years tax-free
Cost segregation
Seller financing
Hold properties for more than a year
Realize appreciation by borrowing, not selling
Tip #1: 1031 Exchange
A 1031 exchange, named after Section 1031 of the Internal Revenue Code (IRC), is a tax-deferred exchange allowing an investor to sell a property and reinvest the proceeds in a new property, deferring the capital gains tax that would typically be due upon the sale.
The key requirements for a 1031 exchange are:
Like-Kind Property: The property being sold and the property being acquired must be of like-kind, but this definition is relatively broad, encompassing various types of real estate.
Qualified Intermediary (QI): A QI must be used to facilitate the exchange. They handle the funds from the sale of the relinquished property and ensure that the money is not received by the seller, thereby preserving the tax-deferred status.
Timelines: There are strict timelines to adhere to in a 1031 exchange. The replacement property must be identified within 45 days of selling the initial property, and the acquisition must be completed within 180 days.
Equal or Greater Value: The value of the replacement property must be equal to or greater than the value of the relinquished property to defer all capital gains taxes.
By meeting these requirements, a real estate investor can defer paying capital gains taxes that would have been incurred if the sale proceeds were not reinvested in a like-kind property. It's important to consult with tax professionals or financial advisors familiar with 1031 exchanges to ensure compliance with IRS regulations.
Tip #2: Die (morbid, but real life) while owning your properties
This concept is also referred to as the “"swap till you drop" strategy or “defer, defer, defer, die”. When an investor holds onto property acquired through a 1031 exchange until their passing, their heirs can receive the property at a "stepped-up" basis. This means that the property's value is reassessed to its current market value at the time of the original owner's death. As a result, an heir potentially inherits the property without any capital gains tax liability based on the increase in value during the original owner's lifetime. It's a way to essentially avoid paying the capital gains tax altogether.
Tip #3: Sell your primary residence of 2 years tax-free
The IRS offers a beneficial tax provision known as the capital gains exclusion for primary residences. If you've lived in your home as your primary residence for at least two out of the last five years, you can qualify for a significant tax break when selling your home.
Single filers can exclude up to $250,000 of capital gains from the sale of their primary residence, while married couples filing jointly can exclude up to $500,000. This means if your profit from selling your home is within these limits, you won't owe any capital gains tax on that amount.
However, there’s some criteria to keep in mind:
Ownership and Residence: You must have owned the home and used it as your primary residence for at least two years within the last five years before the sale.
Frequency of Use: Generally, this exclusion can be used once every two years.
Capital Gains: Any profit above the exclusion amount might be subject to capital gains tax unless you qualify for another exclusion or benefit.
Always double-check current IRS regulations or consult with a tax professional to ensure you meet the criteria and understand any changes in the law.
Tip #4: Cost Segregation
Cost segregation is an advanced tax strategy used by real estate owners or investors to accelerate depreciation deductions on their properties, leading to potential tax savings.
In real estate accounting, properties are typically depreciated over lengthy periods, such as 27.5 years for residential properties or 39 years for commercial properties, based on their classification. However, cost segregation allows property owners to identify certain components of the property that can be reclassified to shorter depreciation periods. Most of the time they need to be done within the first year of you owning the property.
For example, elements like carpeting, lighting fixtures, specialized electrical systems, or certain parts of the building structure might qualify for shorter depreciation schedules. By segregating these components from the overall property, property owners can accelerate depreciation deductions, reducing their taxable income and potentially saving on taxes in the earlier years of ownership.
Cost segregation requires a detailed accounting analysis to identify these components and correctly allocate their costs. While cost segregation can provide significant tax benefits, it's essential to comply with IRS guidelines and ensure accurate documentation and assessment to support the reclassification of property components for tax purposes. Consulting with tax professionals or specialists in cost segregation is often recommended to navigate this process effectively.
Tip #5: Seller Financing
Seller financing has multiple benefits including the ability to defer capital gains taxes. For example, if you sell a property using a traditional approach, you receive the sale profits all at once (typically within one month). With seller financing, you receive sale profits little by little, typically every month for months or years on end. With profits delivered overtime, your total income is spread out for the year, which allows you to decrease your tax bracket. If it is more than a year, you would focus on long-term capital gains.
Here are the general capital gains tax rates:
0% Capital Gains Tax Rate: If your taxable income falls within the lowest tax brackets, you might qualify for a 0% capital gains tax rate on certain long-term capital gains. For 2022, this applied to single filers with taxable income up to $40,400 and married couples filing jointly with a taxable income up to $80,800.
15% Capital Gains Tax Rate: For individuals whose taxable income places them in the middle-income tax brackets, the capital gains tax rate is 15%. For 2022, this applied to single filers with taxable income between $40,401 and $445,850, and for married couples filing jointly with a taxable income between $80,801 and $501,600.
20% Capital Gains Tax Rate: Taxpayers with higher taxable incomes fall into the highest income tax brackets and are subject to a 20% capital gains tax rate. For 2022, this applied to single filers with taxable income above $445,850 and married couples filing jointly with a taxable income over $501,600.
Say for example, you will profit $500,000 from the sale of your property. In a traditional sale, you would need to pay 20% in capital gains taxes. However, if you use seller financing, you can spread that profit into 5 payments of a $100,000 in 1 to 5 years, which saves you 5% on capital gains taxes by lowering your bracket. Obviously, you have to account for your other income, but the overall goal with seller financing is to spread out your tax liability and hopefully pay taxes at a lesser tax bracket.
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Tip #6: Hold properties for more than a year
Holding investment properties for more than a year often provides certain tax advantages related to capital gains. When you hold a property for longer than a year, any profit realized upon its sale is considered a long-term capital gain. Long-term capital gains are generally taxed at lower rates than short-term gains. These rates are subject to change and can vary based on factors such as filing status, total income, and other sources of income.
0% for certain taxpayers: Those in the lower tax brackets (typically with lower incomes) may be eligible for a 0% tax rate on long-term capital gains.
15% for most taxpayers: This rate applies to long-term capital gains for individuals in the middle-income tax brackets.
20% for higher-income earners: Taxpayers in the highest income tax brackets may face a 20% tax rate on long-term capital gains.
Taking advantage of long-term capital gains rates can significantly reduce your tax burden when selling investment properties. It's important to consult with a tax advisor or accountant to understand your specific situation and to make strategic decisions regarding when to sell properties for optimal tax benefits.
Tip #7: Realize appreciation by borrowing, not selling
Realizing appreciation by borrowing against an asset instead of selling it outright is a strategy known as leveraging. In the context of real estate, this often involves taking out a loan or a line of credit using the property's equity as collateral.
Here's how it works:
Equity: As a property appreciates in value over time, its equity increases. Equity is the difference between the property's market value and the amount owed on any existing mortgages or loans secured by the property.
Leveraging: Instead of selling the property to realize the appreciation and generate cash, an owner might opt to borrow against the property's increased equity. This could involve taking out a home equity loan, a cash-out refinance, or a line of credit against the property.
Refinancing involves replacing an existing loan with a new one, usually with better terms, to save money or achieve specific financial goals. In real estate, refinancing commonly refers to replacing an old mortgage with a new one that has more favorable terms.
Here are the key aspects of refinancing:
Lower Interest Rates: One of the primary reasons for refinancing a mortgage is to take advantage of lower interest rates. If interest rates have dropped since you took out your original mortgage, refinancing can allow you to secure a new loan with a lower rate, potentially reducing monthly payments or the total interest paid over the life of the loan.
Change in Loan Terms: Refinancing can also involve changing the loan terms. For example, you might switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage to lock in a stable interest rate. Alternatively, you might extend or shorten the loan term (e.g., going from a 30-year to a 15-year mortgage) to adjust your monthly payments and overall interest costs.
Access Equity: Refinancing can enable you to tap into your home's equity by taking out a cash-out refinance. This involves borrowing more than the remaining balance on your mortgage and receiving the difference in cash, which you can use for renovations, investments, or other purposes.
Consolidate Debt: Some homeowners use refinancing to consolidate high-interest debts, such as credit card balances or personal loans, into their mortgage, potentially reducing overall interest rates and simplifying payments.
Keeping track of all your real estate investment finances can feel complicated. We recommend using Baselane, the #1 banking platform built for real estate investors. It’s banking, online rent collection, bookkeeping, analytics, and more - all in one place. Open a free account today!
As a real estate investor, these tax strategies and tips can help optimize your finances while minimizing your tax burden. We are not CPAs or tax attorneys, so be sure to consult with a tax professional for any highly-specific questions. Need more help? Check out our recommendations below to get ahead in your real estate investment journey!
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