Who does not want tax-free wealth? Well, we do and I'm certain that anyone reading this blog is here to know “How do I get out of paying so much taxes?” Investing in rental real estate is one of the best ways to earn tax-free wealth. The tax benefits you get through investing in Real Estate is so amazing that you can go and invest in another property with all the tax savings. And the great news is, it doesn’t lower your cash flow or wealth! Isn’t this amazing? This is the power of real estate.
Let’s discuss the tax benefits you get from investing in real estate.
Tax Benefits #1: Deduct Expense:
All rental properties have expenses. From paying property taxes to utilities, maintenance, insurance, and management fees all come under expenses that incur in your property. These expenses are all deductibles. But you’ll have to make sure of a few requirements for them to consider as an expense:
Business Purpose: This is an obvious one. The expenses should be reasonable and relate to the business.
Ordinary: These expenses should be typical expenses happening in your property.
Necessary: How will the expenses help the business grow? The expenses should directly relate to the increasing revenue of your property.
Document: All the expenses need to be documented. This is the most crucial one. If you don’t have it documented, then the deductions can be disallowed.
Tax Benefits #2: Depreciation:
Depreciation is an essential aspect that helps you from taxes. Depreciation is a deduction that is made for the wear and tear of your property. It depends on the cost of your property and the number of years the property is expected to last. The main thing to understand is, the faster the property depreciates, the more tax savings you get. If you understand the depreciation concept, then you are on the path to saving thousands of dollars.
The property that has a lifeless than 20 years can be depreciated in the first year. This is called bonus depreciation. The property does not mean the land or the building itself, but other components. In order to calculate depreciation on your property properly, you need to understand that the property can be broken into components. These components have their own useful life.
Component #1: Land: The land never depreciates so we don’t need to worry about it.
Component #2: Building: Depending on your property, the building lasts for 20-50 years.
Component #3: Land Improvements: These are the additions to the building which include lighting, parking areas, and landscaping. These last for 10-20 years.
Component #4: Contents: These include all the windows, cabinets, and floorings in your property. The last 5-10 years.
Here is an example of how cost segregation can accelerate depreciation.
Let’s say a $2,000,000 property is purchased. Without cost segregation, first-year depreciation is approximately $40,000 (2,000,000* 80%/40). If you are in a 40% tax bracket, your tax savings are $16,000.
With cost segregation, first-year depreciation can be as much as $625,000. The tax savings are as high as $250,000! Here is how it gets calculated.
2 M total cost
20 % land = 400, 000
50% bulding = 1,000, 000 (/40 years = 25,000)
20% content = 400, 000(bonus depreciation)
10% land improviemnt = 200,000(bonus depreciation)
Total: 625, 000 Tax saving. If you are in the 40% tax bracket, your tax-saving is 250, 000.
So your total tax saving improved from 40000 depreciate * 40% = 16,000 Cash
to 625, 000 *40% = 250, 000 Cash from tax saving.
Tax Benefits #3: Like-Kind Exchange ie. 1031 exchange
A like-kind exchange saves you from paying taxes on the capital gains you get after selling a property for profit. When you buy a property equal to or more than the property you sold, you get to postpone the capital gain tax you have to pay on your sold property. For this benefit to work, you need to make sure that you are reinvesting the gain you got. If you keep on selling and buying property, you get to defer the tax payment and never pay taxes!
Tax Benefits #4: Opportunity Zone Tax Defer Solution
Are you struggling for you need to pay lots of tax this year due to your stock growth? Don't worry the opportunity zone defer solution might able to help you. The investor can defer tax on any prior eligible gain to the extent that a corresponding amount is a time invested in a Qualified Opportunity Fund (QOF). The deferral lasts until the earlier date on which the QOF investment is sold or exchanged, or December 31, 2026. So if you are not qualified for the real estate professional this year, you can defer your tax payment into 2026 by purchasing the property in the opportunity zone.
Tax Benefits #5: Debt
We mentioned in our previous benefits section that more the deductibles we have in the property, the better. Debt is tax-free and the interest paid on the debt is deductible. Debt allows more property to be purchased which then increases the depreciation deduction. Here is an example of the impact of debt on depreciation. A $200,000 property is purchased for cash. Assuming bonus depreciation applies to 30% of the purchase price, bonus depreciation is $60,000. If the property is purchased using debt, then the $200,000 can be used as a down payment on a $1,000,000 property with $800,000 debt. Assuming bonus depreciation applies to 30% of the purchase price, bonus depreciation is $300,000.