By: Nathan Metheny, Managing Principal/Co-Founder
Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.” Although taxes are an inescapable aspect of life, they are certainly favorable towards the real estate investor.
Benefit #1: Depreciation
Depreciation - a reduction in the value of an asset with the passage of time, due in particular to wear and tear.
The first and strongest benefit of real estate investing is the use of depreciation. Although real estate appreciates over time, the IRS allows you to claim depreciation; enabling an investor to shelter income from taxation. Unlike most operating expenses, depreciation is a “paper loss,” meaning an investor claims the expense but does not spend any money. According to the IRS, a commercial real estate asset depreciates over 39.0 years. A $1,000,000 building depreciated over 39.0 years provides a tax shelter for $25,641 per year.
Example without depreciation expense:
$30,000 taxable rental income x 25% federal income tax rate = $7,500 taxes owed
Example with depreciation expense:
$30,000 rental income - $25,641 depreciation expense = $4,359 taxable income
$4,359 x 25% federal tax rate = $1,090 taxes owed
Depreciation expense is always deductible against rental income and all other passive income, but after the Tax Reform of 1986, depreciation incurred changes as it pertained to non-passive income; depreciation is not deductible against non-passive income. Although depreciation expense cannot shelter non-passive income, there are three main exceptions to the rule.
1. Real Estate Professional – If you or your spouse are considered a real estate professional under the IRS standards, you can deduct all rental related expenses against non-passive income.
2. Year of sale – in the year that you sell your investment, you can deduct all rental related expense against non-passive income.
3. Income Exception – if your non-passive income does not exceed $100,000 and you actively participate in the management of your investment, you can deduct up to $25,000 worth of rental related expenses against your non-passive income.
The common saying is, “what the IRS giveth, the IRS taketh away.” At the time of the sale of your real estate asset, the IRS reclaims a portion of the depreciation expenses through recaptured depreciation, requiring an investor to pay a 25% tax rate on all depreciation claimed.
Fortunately, there are incentives that enable you to delay the recaptured depreciation tax as well.
Benefit #2: Rental Income Not Subject to Payroll Tax
Payroll tax, or FICA, includes taxes such as social security and Medicaid. Depending on a person’s income, they could be paying large amounts towards social security and Medicaid. On average, if you are not self-employed, the rate is 7.65% of your salary. Someone making a salary of $100,000 will be forking out $7,650 towards payroll taxes. Conversely, an investor with $100,000 in rental income pays a total of $0 towards payroll taxes. The latter option is the common favorite.
Benefit #3: Low Capital Gains Tax Rate
Capital Gain - a profit from the sale of property or an investment.
Depending on your tax bracket, as of this writing, long-term capital gains tax is 0%-20%. In comparison, also depending on your tax bracket, the ordinary income tax can reach as high as 37%. Lower capital gains tax allows an investor to strategically supplement his income while subjecting it to the lower tax rate.
Benefit #4: The 1031 Exchange
1031 Exchange - Under Internal Revenue Code Section 1031, you are not required to recognize a gain or loss when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind.”
How can you delay the capital gains and recaptured depreciation taxes? Introducing the 1031 Exchange. This tax incentive enables you to delay paying the capital gains and recaptured depreciation taxes previously discussed. If performing a 1031 exchange, you are qualified to reinvest 100% of the proceeds from the sale into a like kind real estate asset being purchased; you now experience tax-free growth and compound your investment capability.
For example, you sell a property for $500,000 without the use of a 1031 exchange; this means a capital gains tax - at a 15% rate - in the amount of $75,000 is required to be paid. By making use of the 1031 exchange, the $75,000 will be reinvested; at a 15% annualized return over the course of 10 years, the initial investment of $75,000 would grow to $300,000.
There is currently not a limit on the amount of times you can perform a 1031 exchange, allowing you to keep delaying capital gains and recaptured depreciation tax as long as you would like. The only obstacle forcing you to eventually pay the taxes is death, but even then real estate taxation is quite advantageous! If your heirs decide to sell the property after it is inherited, they would receive a stepped-up basis, selling with no capital gains to pay. However, your heirs would still be responsible for an estate tax; up to $11,500,000 is exempt from estate taxes.
Benefit #5: Appreciation Is Not Taxed
During the hold period your real estate asset will most likely increase in value; known as appreciation. Although you will pay tax on the gain at the time of the sale, unless you 1031, you can allow your net worth to compound unhindered by tax exposure during the hold period.
These five benefits are the main tax incentives involved with real estate, but there are plenty more not mentioned. Wealthrise encourages you to perform your own research and dig into the tax reduction techniques pertaining to real estate investing!
With the help of Wealthrise, you can make use of these tax benefits through investing in commercial real estate. Sign up for our monthly newsletter to learn more about the benefits of real estate investing and the many ways that you can get involved.
Disclaimer: Information contained herein has been secured from sources believed to be reliable but should not be considered tax advice. Wealthrise makes no representations or warranties as to the accuracy of such information and accepts no liability. We suggest that you consult with a tax advisor, CPA, financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax implications associated with any investment.
About the Author: Nathan Metheny is Co-Founder and Managing Principal at Wealthrise. In this capacity, his primary roles include acquisition supervision as well as setting the long-term strategy and trajectory for the company.