As a software engineer, I got used to the fairly high withholding of taxes.  Living in NYC meant that I am also hit with NY tax and city tax.  It was just something I took for granted.  As a W2 employee, that chunk that goes to Uncle Sam is quite high.

I always heard about the tax exemptions in real estate so I looked more into it.  It turns out that the tax code is built in such a way to incentivize investing in real estate.  I’m not going to go into the history of why it is built that way as that is for another time, but I want to dive into what that means for those of us that invest in real estate.

What I wanted to do with my hard-earned money is to invest it in a way that makes sense and gives me strong returns.  If there is a way to make my money go further because of tax incentives, then that is another outstanding upside to investing in a particular way.  I always knew there were tax incentives for purchasing a primary residence, but I also learned that there are tax incentives to passively investing in real estate as well.

The following are 5 tax benefits to investing in real estate.

Note: I’m not a CPA, so definitely consult one when you want to utilize these tax incentives/breaks.

1. Deductions

This is one most people are familiar with, in particular when it comes to a primary residence.  Property taxes, insurance, mortgage interest, property repairs, and management fees are deductible.  A lot of people are motivated to buy a primary residence because they do the math and it looks like they can save money as compared to renting when they deduct mortgage interest for example.

On the investment side of things, owning real estate and renting it out is treated as a business.  This means property repairs and management fees are also deductible.  This helps the bottom line, you could accumulate enough deductions that you don’t have to go and pay taxes on the income generated by the rental property.

2. Depreciation

This is a very important benefit and the one that most people overlook because they don’t understand what it means or how to use it.  If you own a property and run it like a business (e.g. you rent it out for income), you can depreciate the cost of the property over time.  You’ll want to consult a tax professional, but the idea is that the building (not the land) depreciates over a period of 27.5 years.  This means even though you can potentially be making money from the rent and the value of your property may actually be appreciating, you can write off a loss via depreciation.  For many rental properties, this means that you can write off all or most of the income.

Example

For example, you bought a single-family home for $100,000 and rent it for $1000 a month.

Let’s say you financed it for 20% down, then you’re looking at about $700/month in payments on tax/mortgage depending on your interest rate and taxes in the area of the house.  You may think you have to pay taxes on that $300/month of income ($3600 for the year), but this is where depreciation comes in.  You can only depreciate the building so let’s estimate that at $85,000.  $85,000 / 27.5 is ~$3000.  You could write off $3000 in losses each year for 27.5 years.  If you made any improvements over that year, then you may also have a deduction.  Either way, you can write off $3000 in losses when you actually gained $3600 in rental income, and excess losses can be carried forward to the next year.  Pretty cool!

Bonus Depreciation

The tax cuts in the JOBS Act of 2017 added what is called bonus depreciation.  This allows businesses to accelerate depreciation and take it as early as the first year. This means there is potentially a larger write-off than the example given above.

This has a big impact, especially when investing in large multifamily properties. For example, if an apartment building is worth $4 million, the investors are able to deduct $1 million in the first year of the investment (we are estimating the deduction is roughly 25% percent of the building). The distributions that the passive investors receive from this investment would show up as a loss on paper due to the large amount of depreciation. This could also offset gains from other real estate investments.

Depreciation Recapture

Depreciation is considered a loss, but when the underlying asset is sold and likely for more money than the original purchase price, the write-offs (“losses”) are recaptured.  This means that you may have bought a house for $100,000, but sold it for $200,000 later.  You may actually have more than $100,000 in gains because of the depreciation written off over the hold period.  However, this is maxed out at 25% which is less than higher income tax brackets.  Another benefit is that you can write off “losses” from other real estate investments that are depreciating against these gains.  A blog post for another day, but there is something called a 1031 exchange where you can buy a similar asset and push off paying the appreciation taxes and depreciation recapture.  This is a process with a lot of rules and you’ll want to work closely with a tax professional to do this right.

3. Capital Gains

Capital Gains are the profits from selling an asset.  As anyone who’s invested in the stock market knows, long term capital gains are taxed lower than income.  The same holds true for real estate.  The appreciation of an asset is taxed at a lower tax bracket than income.  Income invested in real estate is more tax-efficient than my day job as an engineer!

4. Refinancing

Refinancing is a great way to get more capital to invest elsewhere.  Sometimes the General Partners of a syndication do this, but any person or company owning real estate can pull money out of an asset via refinancing.  Times you may refinance is when you’ve owned an asset for a while and have paid down a significant amount of the mortgage (or debt service) or if there has been a decent amount of appreciation.  Refinancing is a great alternative to selling since you don’t pay taxes on money that is borrowed, but you can pull that capital out and invest it elsewhere without paying taxes on it.

5. Carried over losses to future gains

The deductions and depreciation may add up to a net loss on paper.  These can be carried over to subsequent years to be used as write-offs in the future.  There is also a way to convert these passive losses into active losses and write them off of other active income when you qualify with Real Estate Professional Status.  This is something that is hard to do while working full time in another field.

Conclusion

Real estate allows for many tax advantages from intentional incentives set up by the U.S. government.  Some of the examples I used are simple examples of single-family homes, but this can be applied and often amplified when buying multifamily real estate.  Passive Investors in multifamily real estate receive a K1 which outlines all of the depreciation that is part of their share in ownership.

As an investor it is important to know about tax advantages like these, they are powerful when used correctly. With that said you shouldn’t make an investment decision solely based on tax benefits. Having a CPA that understands the nuances can be a huge help to make things easier for you.