Peter bought his first investment house last year and has been busy rehabbing the property in anticipation of selling it. If things go well, he plans to make a business of buying distressed properties that he can fix up and sell. But, he was a little confused about how this will impact his tax obligations. After all, every penny paid in taxes affects an investor’s bottom-line returns and Peter wants to be sure he builds his business strategically. So, I sat down with Peter over coffee to provide a broad overview of the deductions available when you buy and sell properties as an investor.
Taxes can be a complicated subject for new real estate investors. You will need to first figure out if your real estate holdings are considered a personal investment strategy or a business. This will define how you approach each available tax deduction. Some deductions can be taken annually and others are available only as a method to mitigate capital gains when you sell. Also, the way you approach taxes will change if you decide to maintain a property as a rental holding.
Deciding Whether to Itemize
When filing personal taxes, you have the option to either take the standard deduction or to itemize your deductions. To decide which path is best for you, you should always counsel with your financial advisor. But for a general idea of what these taxes may cost you, compare the standardized deduction in the chart below to the total amount of total tax deductions you qualify for, including all of your real estate deductions. Generally speaking, the more tax obligations you have, the greater the potential benefit from real estate tax deductions. To take advantage of these deductions for your real estate investments, your taxes may inevitably become more complicated. Your financial advisor may request that you itemize each deduction to go along with your standard 1040 form. It’s vital that you keep good records!
Standard Deductions for 2018
|Filing Status||Standard Deduction|
|Married Filing Jointly||$24,000|
|Single/ Married Filing Separately||$12,000|
|Head of Household||$18,000|
Before you get too excited about itemizing all those real estate investing deductions in an attempt to decrease your tax bill, I want to mention one critical caveat: If you do several real estate transactions in a tax year—especially if more than half your income comes from real estate—the IRS may consider your dealings to be business-related rather than a personal investment strategy. That’s why it’s important to check with a tax professional early on, when you are still developing your real estate investment strategy. The question of whether your investments are considered personal or business for tax purposes may not only change how your capital gains is figured, but you may also be held accountable for self-employment taxes. It’s not all bad news, though, because you can still develop an effective business strategy to mitigate your tax liability either way. Real estate investing franchisees, for instance, can currently deduct additional costs associated with running their independently owned and operated businesses.
What Tax Breaks are Available to Investors?
Real estate investing provides a broad range of tax deductions, from the minute you sign the documents at the closing table to the time you boost your bank account when you sell. In order to take advantage of them, however, you will need to understand with your financial advisor what deductions are available and plan ahead strategically. Here are some of the best tax deductions to keep in mind for real estate investments:
Secured debt interest.
Any interest you pay on debt secured by an investment property—including a mortgage, home equity loan, or other line of credit—may be deducted. Plus, any points, which are basically prepaid interest, may also be deductible as home mortgage interest.In addition to your main home, however, only one additional property with secured debt can generally be used for tax deductions on interest.
That said, there are certain circumstances in which you can change the property holding that you want to qualify for the deductions. New investors who have just a handful of houses can benefit by using the investment house with the highest interest as their qualifying property, if recommended by their financial advisor.
Be aware, however, that this deduction can be limited if all mortgages you used to buy, build, or improve your first or second property exceed the limitations. For those who file jointly, the limit is currently $1 million (or $500,000 if filing separately). In addition, interest deductions for equity debt—regardless of how the money was used—may be limited to the first $100,000, if filing jointly (or $50,000 if filing separately).
Secured Debt Interest Deduction Limits
|Type of Credit Line||Filing Jointly||Filing Separately|
|Mortgages Used to Buy, Build, or Improve a Property||$1 million limit||$500,000 limit|
|Equity Debt (No Restrictions on How Money Was Used)||$100,000 limit||$50,000|
Generally speaking, you can deduct state and local property taxes that you pay on an investment house, including those paid when you closed on a property—with one exception. If, during the settlement, you agreed to pay any delinquent taxes, you cannot deduct that payment. However, the back taxes would still figure into the cost of the house when you sell.
Different from repairs and maintenance, home improvement adds material value to the property, significantly prolonging its lifetime usability. Home improvement projects can also be used to adapt the property for new uses. When you rehab a distressed property, for instance, you can generally write off projects like installing a new roof or adding an extra bathroom.
Buying and selling costs.
Usually, you can deduct all the costs associated with buying or selling a property, including real estate agent’s commission, legal fees, title insurance, inspection fees, advertising costs, and escrow fees.
In order to take advantage of deductions for depreciation, you must currently hold the property for over a year. Effectively, a depreciation deduction allows you to write off a percentage of the purchase price each tax year. The amount of depreciation that you may deduct can generally be calculated by adding the value of the land and the building structures then dividing the sum by 27.5 years of useful life for residential properties, but this should be checked with your financial advisor.
If, for instance, the tax assessor estimates that your investment properties land value is $80,000 and the building value is $120,000, you currently may deduct $7,273 each tax year.
Land Value ($80,000) + Building Value ($120,000) = Cost Basis ($200,00)
Cost Basis / 27.5 Years = $7,273
Alternatively, you could use the Modified Accelerated Cost Recovery System (MACRS) tool, which is based on the recovery period instead of the property’s useful life, and segment your property’s depreciation. This strategy is used by many investors, so ask your tax professional if it could work for you too.
If you are wondering how a 1031 exchange works, let me lay it out simply. When you sell a property, the IRS charges a capital gains tax. Capital gains, simply put, is the difference between what you paid for the property and the sale price, minus the costs for any improvements. If you own the property for more than a year, the capital gain is taxed at a rate of 15%. However, if you hold it for less than a year, you can probably expect the transaction to be taxed as ordinary income —unless you do a 1031, or like-kind exchange.
Named after the IRS code that defines it, a 1031 exchange allows real estate investors to defer any capital gains by investing the proceeds in a similar type of property. There are two time-limit requirements:
- First, you currently must identify a potential replacement property within 45 days and notify the seller (or their qualified intermediary) in writing of your intent to purchase; and
- Then, the property acquisition must be complete by either 180 days of the sale of the exchanged property or by the due date for that year’s tax returns (with extensions), whichever is earlier. To do this effectively, however, you will need to have a solid lead generation strategy, for finding your next investment property at a discount.
There are numerous other 1031 exchange replacement property rules for investors as well, and that’s it’s important to seek professional guidance.
Phew—those are a lot of tax deduction strategies for new real estate investors to understand! There has been an important change that you need to know about. It is generally assumed that Private Mortgage Premiums (PMI) are tax deductible. And, they were…until recently. The PMI deduction expired at the end of the 2016 tax year. This shows how tax policies are always in flux, so it’s important to hire a tax professional to help you.
Planning For Real Estate Investing Growth
As you buy and sell more houses each year, your tax strategy will change. One way that you can avoid having to develop a new understanding of whether your real estate investment activity might be considered a personal investment strategy or business is to simply set yourself up as a business from the get-go. For new real estate investors who want to grow their business, HomeVestors® may be the best solution. Independently owned and operated HomeVestors® franchisees can leverage tried-and-true training, investment tools, and the knowledge base of a large network of other franchise owners. In addition, franchisees can build their investment business with the nationally-known “We Buy Ugly Houses®” brand in their marketing campaigns and direct real estate lead generation strategies that are not available anywhere else.
If you are ready to grow your real estate investing business this year, it’s time to get in touch today.
Each franchise office is independently owned and operated.