Investing in land or a building can be profitable if you know what you’re doing. You can earn money regularly by renting out the investment property, or you can sell it once its price inflates. Either way, there’s a lot of money to earn by engaging in investment properties.
However, the money you earn is typically not final. There would always be a reduction due to taxes. If, for example, you make a total of USD$250,000 in a year from your tenants, this can become USD$230,000 rather easily if the tax rate is at least 10%, reducing at least USD$20,000. While it may just be a small portion of your total earnings for the year, that’s still a lot of money. That’s precisely why saving taxes on your investment property is such an essential skill for real estate investors.
Unfortunately, investment property tax calculations are relatively complex, especially to investors who are just getting started. Nevertheless, you should still be able to reduce taxes with the following methods.
- Making 1031 Exchange Transactions
Ask any experienced property investor about tax deductions, and the first thing that comes to their mind is the 1031 exchange. A 1031 exchange involves selling your existing investment property and using the money to buy a different property. Basically, you’re exchanging one property for another, hence the name. This allows you to avoid paying capital gains tax, making it one of the best techniques there is.
Therefore, saying that it’s a tax deduction method is an understatement, considering how it completely eliminates your tax liability for that particular transaction. So, how can you use this strategy?
Case Study: Suppose you bought a real estate property five years ago for USD$750,000. Due to inflation, the market value for that specific property went up to USD$1,000,000. Considering the massive price increase, you might get excited and sell the property right there and then.
However, since you’ll have to pay capital gains tax, there would be a reduction of USD$25,000. If you don’t want to have even a tiny portion of the profit reduced, you can take advantage of the 1031 exchange. You can do so by selling your current property and immediately buying a new property worth a million dollars.
This would completely relieve you of any tax liabilities, but of course, there are some rules you must follow. Specifically, you need to make the transaction within time limits. Otherwise, the tax exemption won’t apply. Apart from the time limits, there are other rules you must take into account.
Since 1031 exchange transactions are rather sophisticated, it might be best if you consult your accountant. If you don’t have one yet, sites like https://www.peregrineprivatecapital.com and others on the Internet would be an excellent place to start.
It’s quite a handy technique, especially if you’re already thinking of buying another property. But if you’re not, then a 1031 exchange might not be the best method to save tax. There is, however, another method that can reduce your taxes by a considerable amount.
- Wait For Your Investment’s Anniversary
Capital gain refers to the profit you make when selling an investment property. You can calculate the capital gain by getting the difference between the buying price and the selling price. If the buying price is higher, it’d be capital loss instead. Regardless, you’ll have to pay capital gains tax whenever you sell an investment property, which is usually a portion of the profit. So, how does this relate to saving tax?
For starters, there are two types of capital gains: (1) short-term capital gains and (2) long-term capital gains. Short-term capital gain pertains to any profit you get by selling an investment property after holding it for less than a year. Conversely, a long-term capital gain is a profit you get after selling the property after keeping it for over a year.
While both are a type of capital gains, the tax rate for each is different. The tax rate on a short-term capital gain can be as high as 37%, while the maximum long-term capital gain is only 20%, almost half of its counterpart. You can probably guess how this works out.
Waiting for the investment property’s anniversary means any profit you get by selling it would be considered as a long-term capital gain. When that happens, you’ll enjoy a generally lower tax rate.
Case Study: Suppose you buy a USD$200,000 property. After eight months, the price shot up to USD$250,000. You can get back at least USD$232,000 after taxes by selling it right there and then. But if you wait for four more months, the tax rate would decrease, and you can get back at least USD$240,000 from your investment, which is unquestionably better than the previous amount.
This and the previously mentioned technique are ideal tax-deferring or reducing strategies for those who buy properties when the price is low and sell them when their market value increases. Unfortunately, this technique doesn’t have any value to those who profit solely from rental properties since it doesn’t involve capital gains tax. If you’re unfamiliar with the two types of investment property tax, it might be best to go over that topic before proceeding to other techniques.
- Capital Gains Tax And Income Tax
As you may already know, there are two types of investment properties:
- Properties that you buy solely for the purpose of selling them at a higher price in the future; and
- Properties that you buy so you can rent it out and profit from your tenants.
While both of them are investment properties, the way tax works on each one is different.
The first type deals with capital gains tax and this guide have already tackled the two best ways to reduce and even exempt you from such tax. Meanwhile, the second type deals with income tax. The good news is that you can save on both. In other words, if you own a rental property, you can still save on taxes, and what better way to do this than by claiming or including rental expenses on your tax reports.
- Claiming Rental Expenses
When managing a rental property, you’re inevitably going to spend money on various things to keep the property appealing to tenants and adhere to local safety regulations. You need to hire a team to do pest control, purchase cleaning products, and hire plumbers or technicians if there’s a problem with the property. These are what you call rental expenses and they’re an essential component of your tax calculations. This is mainly because you can reduce your tax liabilities considerably by including them in your report.
Case Study: Suppose the annual income from your rental property is USD$300,000. Normally, your tax would be around USD$30,000 if the tax rate is 10%. If you spent a total of USD$10,000 for various maintenance costs to maintain the rental property in that year, you could include this expense in your tax reports. By doing so, you can potentially reduce the tax to as low as USD$20,000. Take note that the tax deduction may also be just a portion of the rental expense, so this is just an estimate.
Now you might be wondering if you can count any expense as a rental expense. Unfortunately, no, you can’t. The Internal Revenue Service (IRS) has a guideline on what you can consider the rental expense. By hiring an accountant, you should be able to deal with this rather quickly. But for your reference, here are some examples of rental expenses that can be utilized to reduce your income tax amount:
- Pest control;
- Water rates;
- Land taxes;
- Plumbing repairs; and
Now, if you’re fairly knowledgeable of rental properties, you might be wondering if the depreciation of rental assets (e.g., equipment, utilities, building) would count towards this expense. Fortunately, they do, but they work differently from the expenses mentioned above when it concerns taxes.
- Include Depreciation On Your Tax Deductions
Depreciation pertains to the loss of an asset’s value, typically because of wear and tear. For example, if you have a car that originally costs USD$50,000 and you’ve been using it for eight years, it’s safe to assume that the value would be a lot lower now. Eventually, once it reaches the end of its lifespan, its value would drop to zero dollars.
Therefore, if that car has a lifespan of 10 years, you can say that each year, its value depreciates by USD$5,000. So, what does this have to do with saving taxes?
For starters, depreciation can be counted as an expense, or in your case, a rental expense. And as always, with rental expenses, you can include them on your tax reports to reduce the total amount.
Case Study: Suppose you bought a rental property for USD$275,000. According to IRS, the lifespan of residential properties is 27.5 years. That means every year, the value of the rental property would go down by USD$10,000. This would also mean that you can reduce USD$10,000 from your tax liabilities every year, which is an incredibly huge amount. It doesn’t matter if the property rises in value or if it remains in tip-top shape after 25 years. You still enjoy the tax deduction every year.
Although it may sound simple enough, it’s not. Many factors affect the depreciation of a property such as its basis, its recovery period, and the depreciation method you plan to use. Hence, your best bet is to seek the assistance of an accountant or any financial expert for that matter.
There are several other ways to save tax on your investment property. These four are just the best methods there are. Of course, you have to remember that there’s a lot going on behind these calculations. This guide just oversimplified the process. If you’re not exactly an expert in accounting, you might struggle with the process. For that reason, it’s generally a good idea to get a consultant to help you out.