5 Things Every Passive Real Estate Investor Should Know About Taxes
Real estate investing, regardless of whether you're a novice or an adept investor, always sparks questions about taxes. Fortunately, when compared to other investments, Uncle Sam tends to favor real estate ventures the most. Wondering why? It's simple, although there are many facets to the industry of real estate, one major contribution this sector provides is housing; an essential need for any individual. As such, a syndicated real estate investment can be a very effective tax strategy for high net-worth individuals interested in reducing the amount of taxes they must pay each year.
Before we move into the 5 things every passive real estate investor should know about taxes, we want to be clear - we are not tax professionals. The insights we're providing below are based on our own experiences and conversations we've had with our own CPAs and other tax professionals. Always speak with your tax professional to discuss what is best for your unique, financial situation.
Okay, let's dive in.
5 Things Every Passive Real Estate Investor Should Know About Taxes
Take Advantage of Depreciation One of the most powerful wealth-building tools in the real estate world is depreciation. It is a tax strategy real estate investors can use to reduce the amount of taxable income they report on their tax return. By depreciating real estate investments over time, real estate investors can defer or reduce taxes on real estate income. Here’s how it works: Depreciation allows you to write off an asset's value over time, typically based on wear and tear and the useful life of an investment. The IRS acknowledges that every property goes through its fair share of wear and tear and regular maintenance and improvements are needed, otherwise it will one day become uninhabitable. Because of this, the IRS allows investors to write off the value of a property over the course of 27.5 years when it comes to residential real estate. Keep in mind, depreciation only applies to the property, not the land. Remember, bonus depreciation began phasing out - with 100% phase-out in 2022 and phase out in 20% increments every year through 2027 when it will finally reach 0%.
Familiarize yourself with Cost Segregation Cost segregation accelerates depreciation deductions on a passive investor's investment properties, resulting in significant tax savings. We may have gone a little too fast there. Let’s slow it down a bit. In the above point, we focused on straight-line depreciation of an asset over the course of 27.5 years. But with real estate syndications, the hold time is typically just around 5 years. This means we would be leaving 22.5 years of depreciation benefits behind - what a loss! This is where cost segregation comes in. It recognizes that not every subcomponent of a property is created equal. This is where a cost segregation study comes into play and a specialized engineer is brought in to itemize individual elements that make up a property - think plumbing, wiring, flooring, etc. which can then be depreciated on a shorter timeline, like 5 - 7 years. As a result, you can enjoy a drastic increase in depreciation benefits in the early years of your investment.
Understand Capital Gains tax and Depreciation Recapture Capital gains tax is a tax on the profit made from selling an investment property while depreciation recapture, on the other hand, is a tax on the amount of depreciation that was previously taken on the property. As we now know, there are quite the many tax benefits real estate investors enjoy, but nothing is 100% tax-free - hence why you must understand these two key elements. Essentially, the IRS earns its share through capital gains taxes once your real estate asset is sold and through depreciation recapture. Note: the specific amount of capital gains and depreciation recapture depends on the length of time you held the property, as well as your tax bracket. You might think, well what’s the point of pulling forward depreciation, if you just have to pay it back later. This is where the Time Value of Money concept comes in. If you understand this concept, you are on your way to being a more intelligent investor.
Know that passive losses can be carried over to the next year Passive losses, which can represent your depreciation, may not be utilized fully each year. Perhaps in Year 1 of an investment, a cost segregation study yielded $30,000 in pulled forward depreciation. But the income received from this passive investment was $10,000 in passive income. This leaves you with $20,000 unused passive losses. These losses can be carried forward to the following year. If you have unused passive losses, talk to your accountant on how to best utilize these in the future.
Understand the impact of Section 1031 exchanges on real estate transactions and capital gains taxes Section 1031 of the U.S. tax code states that real estate transactions can qualify for a tax deferral if certain conditions are met. Real estate investors can take advantage of this opportunity by selling one investment property and reinvesting the profit into another similar investment property, thus allowing them to defer capital gains taxes on the real estate transaction until they sell or dispose of the new real estate asset. This provides passive real estate syndicators considerable financial benefits when reinvesting in real properties, as they will only pay capital gains taxes on the difference between their original investment and sale price, rather than paying it up front when transitioning into a new real estate venture.
In conclusion, if you want to minimize your real estate investment tax liabilities, it's essential that you understand the tax implications associated with your ventures. Taking advantage of deductions, capital gains and other tax strategies will help you maximize profits while reducing liability obligations in the long run. Make sure to consult with a qualified certified public accountant if you have any questions. They can provide valuable insight into real estate taxation, so don't be afraid to ask for help. Real estate syndications offer real estate investors great ways to reduce tax liabilities and maximize profits, making them a serious contender for those looking to diversify their investment portfolio. With the right knowledge and understanding of the tax implications that come with real estate investing, you can rest assured knowing your investments are both safe and profitable!
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