Real estate assets are a good way to generate wealth, but as with any income, they are subject to taxes. The great thing about taxes on real estate assets is that you can deduct expenses, reducing your taxable liability. Various tax planning strategies can help you defer, reduce, and even avoid taxes. In this article, we’ll review some real estate tax planning strategies to help you prepare for your annual filing.

Key Takeaways

• Real estate tax planning involves creating a strategy that reduces your taxable liabilities.
• Every real estate investor should have a tax planning strategy to help control taxes and expenses.
• Including additional real estate assets in your portfolio can help reduce taxes.
• Tracking real estate expenses throughout the year will make it easier to file your taxes without missing any important deductions.
• Working with a professional is the best way to ensure you receive all taxable deductions and credits.

What Is Real Estate Tax Planning?

Real estate tax planning is finding the best way to file, categorize, and structure your assets to reduce taxable liability. Owning and managing real estate assets is a business, which means you can deduct expenses from your income. The Internal Revenue Service (IRS) also allows you to take advantage of certain strategies, such as a 1031 Exchange and cost segregation, to reduce your taxable liability further.

Real Estate Tax Planning Strategies

Every real estate investor should have a tax planning strategy that helps them manage expenses and maximize profits. Here are a few excellent real estate tax planning strategies:

Expand Your Portfolio

The old saying goes, “If you’re a real estate investor and you’re paying taxes, you don’t own enough real estate.” Whether you want to start investing in real estate or expand your portfolio, it’s possible you already have the funds available. One way to add to your portfolio is to roll your retirement funds into a self-directed individual retirement account (IRA).

Rolling your current retirement plan into a self-directed IRA frees up money to purchase more real estate assets. The best part of this strategy is that you don’t have to pay taxes on earnings until you collect the required distributions. If you opt for a Roth IRA instead, you’ll never pay taxes. If you have a business, you can also create a 401(k) with Anderson Advisors and use it to purchase additional real estate assets.

Carefully Track Expenses

Keeping clear, detailed records of expenses is crucial to any business. This bookkeeping process may also help when filing your taxes. Monitoring your income and expenses throughout the year in an organized way is much easier than trying to track down these costs before the tax deadline.

Most real estate investments have expenses, including taxes, property management, repairs, renovations, marketing costs, and depreciation. The IRS allows you to deduct these expenses from your income, thus reducing your taxable liability. Clear records may be even more helpful if you own multiple real estate assets. Make sure you’re tracking which asset or property each expense goes with. Detailed records will also be useful when using other real estate tax planning strategies, such as depreciation or cost segregation.

Take Advantage of a 1031 Exchange

Another useful strategy is using a 1031 exchange to defer your capital gains taxes. A 1031 exchange allows you to sell assets and roll earnings into additional, similar real estate properties. With this strategy, you won’t owe taxes until you sell the final property and collect cash. 

Realistically, you could continue to roll your capital gains into new investments for the rest of your life and never owe taxes. After death, a step-up basis activates, potentially reducing your heir’s taxable liability.

Claim Depreciation

The IRS also allows investors to claim depreciation on a property over many years. The general rule is that you can claim depreciation for 27.5 years for residential properties and 39 years for commercial properties. Some things within a property depreciate much faster. While the home may slowly depreciate over decades, interior features such as carpets, cabinets, and windows have a much shorter lifespan.

Depreciation allows you to take a deduction against your income. The IRS also allows you to accelerate depreciation. For example, you can write off 80% to 100% of assets depreciating in less than 20 years in a single tax year through a passive loss carry forward. The process can be complex, so it’s beneficial to get advice from a professional.

Use the Tax Loophole of Cost Segregation

Cost segregation is another strategy that is best used when working with a professional. This involves allocating the costs of a property among multiple categories rather than the single value of the property. The interesting thing about cost segregation is that many tax professionals and accountants miss it. Most accountants stop at the basic depreciation calculation, which divides the price minus land value by the standard 27.5 years for residential and 39 years for commercial properties. 

Yet, the IRS claims a carpet’s useful life is around five years rather than 27.5 years. Cost segregation allows you to write it off much faster. You can even write it off in one year. Other assets, such as your roof, may last up to 27.5 years. If the roof is older when you purchase the property, you’ll likely have to replace it sooner. When you do, you should claim the rest in depreciation and start over with the new roof. 

You can use this strategy with carpets, roofs, cabinets, landscaping, driveways, and electrical improvements. Most of a property’s interior features don’t last the full 27.5-year depreciation. The useful life of a lot of property is typically between five, seven, and fifteen years. Of course, you can also accelerate a single or all categories to take bonus depreciation in a year when your income is higher—up to a 100% deduction. This strategy also produces a passive loss, which allows you to deduct from passive income, which is how most real estate investors classify their earnings.

Stay Up to Date on Current Tax Laws

A real estate investor must stay current with the latest tax laws and strategies. Tax laws are constantly changing, so staying up to date helps you avoid penalties while ensuring you take advantage of all available tax credits. An example of the importance of staying current with the latest laws is the most recent Secure Act of 2023, which primarily adjusted tax brackets. There were also changes to IRA and 401(k) contributions and solar tax credits. Consulting a tax professional or financial advisor can help you stay current on the latest tax laws.

Qualify as a Real Estate Professional

A real estate professional status allows you to fully deduct losses against your ordinary income. To qualify as a real estate professional, there are rules regarding how many hours you and your spouse must work within the property and whether the property’s management involves other parties. You don’t need a real estate salesperson license to qualify as a real estate professional. Writing off losses and expenses as a real estate professional also requires careful, detailed records, so it’s advisable to work with a professional.

It’s also important to note that qualifying as a real estate professional isn’t the same as becoming a dealer. You don’t want categorization as a dealer since this could subject you to higher ordinary income, social security, and alternative minimum taxes.

File a Trust

Setting up a trust is a common asset protection strategy that offers many benefits, including the ability to reduce federal estate taxes. You’re still liable for taxes, even if you place your assets in a trust. Whether you draft a simple or complex trust, the IRS expects the trustee to file a tax return.  Trustees can file taxes using IRS Form 1041 if the trust has any taxable income. Gross income less deductions greater than $0 or gross income above $600 qualifies as taxable income.

Why Get Expert Advice on Real Estate Tax Planning?

Keeping your tax obligations as low as possible allows you to keep more of your hard-earned money in your pocket. The income saved through our real estate tax planning strategies also gives you more money to invest in real estate or investment assets. At Anderson Advisors, we often recommend calculating your finances and deductions to determine whether a specific strategy benefits your portfolio.

Stay up to date with the latest tax laws by subscribing to the Anderson Advisor YouTube channel. Have you questions or comments on these tax strategies? If you do, let us complete a thorough analysis to help you identify additional ways to reduce your taxable liability. Every real estate asset portfolio is unique, so it’s essential that you choose the strategies that best match your financial goals.