Disclaimer -I am not a CPA or tax attorney, I am just going to give some general information in this post and you should not construe this as advice. Consult the appropriate professional regarding your personal situation.
Everyone is well aware of the tax advantages of investments made into a 401k or traditional IRA, and that its with pretax dollars. This is great and its a big reason why a lot of people put money into these types of investments.
So what if any tax benefits are there to investing in real estate? Well it depends, and there are a lot of factors.
The interest, property taxes, insurance, repairs and many other things are tax deductions that reduce your taxable income as it relates to that property. Those are the commonly known deductions.
The one that not everyone is familiar with is called “depreciation” which I refer to as the phantom deduction. I call it the phantom deduction because it appears out of no where. Unlike the other common deduction types, you don’t actually make an outlay of cash to recognize this deduction. The IRS recognizes that all real property needs to be improved consistently to keep it up. So they allow you to use a prescribed schedule to write off the value of certain assets types over various time periods.
I could go into all of the various types of properties and their respective schedules, but the point is that you can further offset your income. In some cases, depending on how you buy your properties the depreciation deduction could actually push your otherwise profitable property (from a cashflow perspective) into a paper loss on your taxes.
There are limitations on how much money you make and how these paper losses can be taken. Those who make over $100k have their ability to deduct these types of losses phased out until they reach $150k.
The one exception to the passive loss rules is called the “real estate professional designation” and it allows people who work full time in real estate (more than 750 hours, select job types) to be able to claim unlimited passive losses against earned income.
One thing that I have always recommended to married couples in which one of the two is a high wage earner on a W2 is that the other partner work in real estate and invest. Essentially the partner who works in real estate would acquire and manage a real estate portfolio for a living, and the depreciation and other deductions could produce a large negative number. That large negative number gets combined with your partner’s high tax bracket, and would result in a huge tax savings.
One of the best tax benefits to real estate and the final one we will discuss on this quick overview is the tax deferred exchange. Often referred to as a 1031 Exchange after the section of tax code. In essence you can sell a property that was held for longer than a year, and defer what you would owe in taxes on this sale until you sell the next property. The IRS will allow you to roll the proceeds of this sale into the next, tax free if certain conditions are met. By deferring the taxes you keep the full amount of money you’ve made until you decide to cash out.
This is just a high level overview of several very complicated topics. I recommend that you read books on real estate taxation to learn more. Contact me for recommendations which I will make based on your current knowledge level.