When I think back to what I knew about taxes when I was starting out as a real estate investor compared to what I know now, my education has been stratospheric. I’m not claiming to be a tax expert, but I have learned a lot over the years, and the main headline I can share with you is that real estate investing offers tax advantages that few other enterprises do. We are uniquely fortunate to be able to use depreciation to our advantage, to defer large tax liabilities by reinvesting and to deduct all kinds of expenses to minimize our tax liability.
Getting Set Up
One of the most important things you can do at the outset of your career as a real estate investor is to form a limited liability corporation, or LLC. When you take your property or properties out of your name and put them into an LLC, it will help you tremendously and spare you some major headaches. There are several advantages to LLCs, but the chief one is that it protects your personal assets. If you are ever sued for something that happens at one of your properties, you won’t be personally liable and your personal assets are protected. While the requirements and procedures vary from state to state, forming an LLC is a pretty straightforward process and you can file the paperwork for your LLC online. Once you’ve chosen a name for your LLC that no one else is using, you’ll file your articles of organization, which generally require information about the company principals. If you have partners, some states will require an operating contract, which is essentially an agreement among the LLC members about the breakdown of responsibilities, obligations and how profits and losses are distributed. The final thing you need to do to start your LLC is to obtain the business licenses and permits necessary for your industry.
Beyond the liability advantages, there are strong tax advantages to operating as an LLC. A real estate LLC can save you thousands of dollars. It allows for pass-through taxation, which means that the business won’t be directly taxed. Instead, investors report their company’s profits or losses on their personal tax returns. In most cases, this will result in a lower rate for business owners and avoids double taxation.
There are different types of LLCs depending on how many members there are. In a Single Member LLC, the LLC business is not taxed. Instead, the member is taxed through their personal federal tax return. In a Partners LLC, members elect to be taxed as a traditional partnership. Their tax liability is determined by their share of ownership. In a Corporation LLC, members become shareholders. The corporation pays taxes on its income, and as a shareholder you only pay taxes on any dividends you receive.
Adding Properties to an LLC after the Fact
If you need to finance your property as a new investor, it may not be possible to secure financing with your LLC as the lendee. After all, the bank wants to know that they will be repaid, and a brand-new LLC isn’t the safest bet from their standpoint. It may take a year or two to be able to secure financing in the LLC’s name due to it being a new company. As soon as you have a chance, refinance the property in the LLC’s name, even if you must go with another lender.
While real estate investing isn’t the only occupation that allows you to make tax deductions, the volume and variety of them will allow you to hold on to a sizable chunk of your income. When you are a real estate investor, you’re able to make deductions for the construction, management and maintenance of your property. That includes:
- Property taxes
- Property insurance
- Mortgage interest
- Property management fees
- Costs of maintenance and repair
Sounds like a lot, right? Well actually, those are only some of the deductions. You can also deduct for any expenses related to your real estate investing business. That includes:
- Office space
- Office equipment
- Legal and accounting fees
- Any employees or independent contractors you pay
- Travel, including mileage to and from your site
These deductions can really add up. The key to reaping them is to make sure that you are able to provide proof of your expenses, so it’s up to you to meticulously save any receipts, invoices and other documentation of your business expenses. Those receipts are money, so be sure to hand every last one over to your tax preparer.
Depreciation and Cost Segregation
Depreciation is a deduction taken on materials that break down over time. It’s not a concept unique to real estate. In fact, it’s used in most businesses. Typically, real estate investors depreciate their residential properties on a 27.5-year schedule, which is known as straight depreciation. (Commercial properties can depreciate over the course of 39 years.) This depreciation can only be applied to the actual property, not the land it’s on.
Real estate investors can also employ cost segregation, which is a way to accelerate their depreciation. With cost segregation, you can reclassify a portion of your assets as personal property instead of real estate property in order to depreciate them on a much faster schedule (such as five, seven or fifteen years). This lowers your tax liability, allowing you to hold on to more of your income. You can apply segregation depreciation to items such as your property’s carpeting, kitchen appliances, lawn sprinkler system and even the parking lot.
Lower Tax Rates on Capital Gains
A capital gain is the profit you make when you sell an asset for more than you paid for it. A long-term capital gains tax is a tax on any profits from the sale of an asset held for more than one year. For the tax year 2020, the long-term capital gains tax rate is 0 percent, 15 percent or 20 percent depending on your taxable income and filing status. The 15 percent rate kicks in at earnings above $40,000 per year, and anyone earning $441,451 or more would be subject to a tax rate of 20 percent.
The most tax-efficient way of building wealth through real estate is to hold on to your investment properties for as long as possible. Or, as Warren Buffett famously remarked, “my favorite holding period is forever.” When you sell, you pay transaction fees, commissions and taxes. All of these costs will impede your profit because you will forever lose out on the passive income from your property and the long-term benefits of appreciation. Real estate appreciation doesn’t get taxed by the IRS until you sell the property. So, if you buy and hold for many years, your net worth will grow with minimal tax exposure. And when you do choose to sell, the capital gains tax rate is still less than the equivalent income tax on ordinary income, even in the higher capital gains brackets of fifteen or twenty percent.
Once you decide that it’s time to sell, putting your profits into a 1031 exchange will enable you to hold on to your money. The 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale in a property or properties of like kind and equal or greater value. That means you won’t be taxed on any capital gains from the sale, so long as you use all of the proceeds for your new investment.
The Biden Plan
There is a caveat to all of this. Biden, like pretty much every president before him, has said that he’s looking into modifying the existing framework around 1031, capital gains taxes and the step-up basis (casually known as “inheritance tax”). Real estate investors are waiting to see what will happen with the Biden administration’s proposed tax plan, which would raise the top capital-gains tax rate from 23.8 percent to 43.4 percent for those earning over $1 million. The Biden plan has also set its sights on modifying the 1031 exchange. As it currently stands, any amount of money investors place in a 1031 exchange remains tax-free. If Biden’s proposal becomes law, investors would only be allowed to defer taxes on profits up to $500,000. While this would undoubtedly impact high-earning investors, it wouldn’t cancel out the other advantages of real estate investing: cash flow, numerous tax deductions on your investment income and the long-term appreciation of your real estate. Even if Biden’s proposed reforms become law, real estate is still an excellent way to make your money work for you.
Unlike other industries, you don’t need to take a loss in order to have any tax advantages. With real estate, you can reap the benefits of monthly passive income and still be able to experience the tax benefits of real estate investing. You’ve worked hard for your money; now it’s time to make your money work for you.