4. Capital gains taxes instead of income taxes
When you sell a property for more than you originally purchased it for, the profit will be taxed as a short-term or long-term capital gains, which is typically a lower tax rate than ordinary income tax.
Short-term capital gains, which are properties held one year or less, can range from 10% to 37% depending on your income bracket. Long-term capital gains, which are properties held a year and one day or more, are taxed more favorably, ranging from 0% to 20% depending on your tax bracket.
You can utilize certain tax-deferred or tax-free methods of investing in real estate to avoid paying capital gains. These methods are outlined below.
5. Invest tax-deferred or tax-free
Named after Section 1031 in the IRS tax code, a 1031 exchange is a legal transaction that allows real estate investors to swap an investment property for a like-kind property, thereby avoiding capital gains or depreciation recapture on the sale of the property.
Tax-free or tax-deferred retirement accounts
There are special savings accounts like a health savings account (HSA), or special individual retirement accounts (IRA) like a Solo 401k, SEP IRA, or Self Directed IRA that act allows you to invest in alternative assets, including real estate, tax-free or tax-deferred. Annual contribution limits vary depending on the type of account you open, and there are different requirements prohibiting who and what you can invest in with each account, however, this can be a great way to avoid taxes but still invest in real estate.
Opportunity zones are over 8,700 designated census tracts making up some of the most rural and distressed areas of our country. To stimulate growth in these areas, a new tax incentive was rolled out as a part of the Tax Cuts and Jobs Act which allows investors to roll qualified capital gains into an opportunity zone fund, thereby deferring capital gains or paying no capital gains depending on how long the investment is held in the fund.
Since this is still a relatively new opportunity, changes and further clarification of the rules and requirements of this program are being made regularly.
Real estate tax advantages in action
To really show you how these benefits can add up, let's look at an example of a basic real estate transaction that utilizes a few of the real estate tax advantages available today.
You purchase a rental property for $150,000, putting 20% (or $30,000) down. The annual rental income is $16,000 with $13,000 in expenses, giving you a net income of $3,000. With the depreciation deduction, you are able to deduct an additional $5,454, producing a net loss of nearly $2,500. Essentially you get to earn $3,000 a year in passive income, yet pay taxes on none of it. If you have additional passive income that is not a net loss, you can use this passive loss to offset that income.
But that tax savings doesn't end there. Let's assume this is not your only real estate investment, and that you own this property and other real estate investments in an LLC, earning around $20,000 a year in qualified business income. You could utilize the pass-through deduction, reducing your net income by an additional 20% (or $4,000) to $16,000.
You decide to sell the property 10 years later for $200,000 using a 1031 exchange. This helps you avoid having to recapture $54,540 in depreciation and you are able to roll $50,000 of capital gains into a new investment property that produces a net cash flow of $9,000 a year instead of $3,000 a year.
Over the 10 years of ownership, you paid little to no taxes, collecting roughly $30,000 in passive income before converting it into a new investment that yields triple your original return.
While this is a basic illustration of how real estate tax advantages could work, it's not that far-fetched. Real estate is one of the most tax-advantaged investments compared to other investments. Not to mention, there are benefits of real estate that extend beyond this list, such as appreciation, equity build-up, or the ability to leverage your investment. Everyone has to pay taxes, but how much tax you pay can be reduced by utilizing certain tax laws available in real estate.