Updated February 23, 2021
There are plenty of ways, some less obvious than others, to maximize your tax deductions as a real estate investor, but choosing the best strategies requires research, knowledge, and guidance. From the very beginning, you should make sure to keep meticulous records of all of your investments and expenses, and wherever you are in the process of real estate investment, you can likely improve your record keeping system. When you are ready to file your taxes, you will need to submit itemized deductions to most optimally minimize your tax liability. Although standard deductions are tempting because they are faster, itemized deductions with support can be much more financially beneficial.
Generally speaking, taxes are meant to only come out of the profit you have accrued from assets like real estate in a year. The process of maximizing tax deductions is really a process of determining what you actually made in a year and informing the IRS of the expenses you had to manage, so that you are not held accountable for an income you did not receive. Furthermore, real estate investors have special opportunities to take advantage of other tax benefits specific to real estate property like depreciating assets and avoiding capital gains taxes.
Let’s take a look at some deduction opportunities you should be aware of when filing taxes as a real estate investor:
Interest deductions are often the best way to maximize tax deductions. Depending on how you paid for your real estate, you may be paying interest from several sources. This may be interest paid on a mortgage, loan, credit line, points or loan origination fee, etc. While you cannot deduct the portion of payment you are making toward the principal, you can deduct the portion you pay in interest on your taxes. This may be a significant amount. For example, if you are paying a monthly mortgage of $1,000 and $700 of that is going toward your principal, while $300 is paid in interest, this monthly payment of $300 is tax-deductible. Over a year of paying $300 a month, this will accrue to $3,600 of tax-deductible expenses.
Points and loan fees are also deductible. While you cannot deduct the amount that you paid as a down payment, you can deduct any fees associated with taking out the loan.
Other often forgotten interest deductions include interest paid on any unsecured loans or credit card lines used for expenses related to your real estate. Unsecured loans can be tricky to deduct and often require the assistance of an accountant or lawyer. Deducting these expenses, however, can be lucrative. The general idea is that any interest paid on a loan used toward the property is deductible. Any interest paid on a credit line that was used to pay for associated costs to a rental property is also deductible. If you purchased a new oven for a property with a credit card, the interest paid on the monthly payment is tax-deductible.
The pass-through deduction is probably the most exciting and newest deduction on the list. While it is not specifically for landlords or real estate investors, the deduction comes through the Tax Cuts and Jobs Act and applies to any individual who has business income that is reported on their personal tax return, such as LLC’s, sole proprietorships or partnerships. This pass-through deduction is a 20% deduction on taxable business income. The deduction will be effective from the beginning of 2018 and will expire in 2026. It is applicable in a straightforward way for incomes up to $157,500 or $315,000 for joint filers. Incomes over these figures get a little interesting and will likely require a professional to help determine how each specific situation can benefit.
Maintenance and Materials deductions
The IRS distinguishes any expense that is ordinary and necessary for the overall function and well being of a rental property as tax-deductible. This includes expenses that you as the owner pay toward materials and maintenance done to the building, as long as it is not considered improvement of the property structures.
When maintaining your property, there are a few ways to navigate the tax system. As a rule of thumb, replacing or repairing just what was damaged that year will be tax deductible in its entirety in that year. For example, if you replace a section of roof that is leaky or repair a section of a ceiling from water damage, the entire cost can be deducted. If the maintenance you do is an improvement to a property, it will be filed as a depreciation deduction instead.
The depreciation of a property is the recognition of wear and tear on a building over time and treating this like a yearly expense. There are two ways depreciation can come into play for a real-estate owner. The first involves the house or structures as an asset. For residential rental properties, the property is considered to depreciate or wear down in 27.5 years and for some commercial buildings the IRS recognized depreciation to occur over the course of 15 years. To calculate the depreciation value, you take the value of the building and divide it by 27.5 years (or 15 depending on your IRS distinction). That amount is tax deductible. It is important to note that this deduction is applicable only to property that you own for over a year.
The second way depreciation comes into play involves an improvement or update to a property. The IRS makes a distinction between maintenance and improvement by qualifying improvement as something that enhances an asset, restores an asset or adapts an asset to another use. So, if you decided to replace the entire leaky roof instead of just the portion of leaky roof that needed immediate attention, you will not be able to deduct the entire cost of the repair because this is considered an improvement to the building. Instead, the cost of the roof will be divided by 27.5 years (the number of years
the IRS recognizes a property to depreciate over time) and just that much will be eligible each year for tax deductions for 27.5 years.
Property tax deductions
Property taxes are often substantial, particularly if you live in an urban area, and they are deductible. Property taxes can be deducted both for your private residence and any rental property you own. It is important to note that if you purchase a property and agree to pay outstanding property taxes, this will be included with the overall cost of the property and not included in deductible property taxes. Under new tax changes effective January 2018, the total deductible state and local tax deductions on income tax, inclusive of property tax, is now limited to $10,000 a year. You should verify the property tax rate you are responsible for and can deduct.
There are several ways to benefit more effectively from your tax deduction. By prepaying property taxes, you may be able to collect on property tax deductions sooner. Also, be aware that if you invested in a property this year, you may have paid deductible taxes in the original paperwork, even if you were billed later for taxes. This separate tax bill is an adjustment, not a final amount. Be sure you are including all taxes you paid on a property to maximize the deduction.
A 1031 exchange is one of the smartest ways to simultaneously bypass taxes and grow a real estate business. If it is time to sell a property, filing a 1031 exchange allows you to use all of the profit from the sold property to buy another property tax free. You can immediately reinvest the profit from one property into another and pay no taxes on the reinvested property. In order to qualify for this, there are several rules that must be abided by, including being a long-term investor as opposed to a short-term investor or house flipper. This means you must own the property for over a year. In addition, the property must be a “like-kind asset”, meaning that it is a similar kind of property, and be of equal or greater value to the relinquished property. You must identify your replacement property within 45 days of selling your relinquished property. You must additionally close on the replacement property within 180 days and, unfortunately, you cannot touch the money you are reinvesting. If you plan ahead, however, this option can be enormously beneficial to a growing business.
Putting it all into practice
From the onset, keeping track of expenses and profit will always be a benefit in maximizing tax deductions, so that you are set up to determine a thorough list of itemized deductions. By maintaining these records, it will become much easier to find ways in which the costs associated with your real estate assets can be deducted and maximized. There are surprising places to find and squeeze out greater deductions and it is worth the effort and time to find these places. Getting help and support from a professional to ensure that your taxes are properly prepared, and deductions are maximized is also a smart action to take.
Our team at Anderson Advisors would be happy to set up a consultation with you to ensure that you are saving the most in taxes and taking advantage of every opportunity to minimize your tax liability. Contact us today!
3 Steps to Create an Invisible Investor Strategy
The greatest mistake that people make when it comes to asset protection for real estate is not understanding the risks that are waiting out there for them. This eBook reveals the structure you should follow to ensure your hard earned money is protected from frivolous lawsuits and costly tax mistakes.