Real Estate Taxes & Deductions - Coastline Equity

When many people talk about the various benefits of investing in  real estate , they talk about real estate taxes and deductions. Why, you might ask?

Well, I have a good friend I would like to introduce you to. His name is Sam, but most people know him by “Uncle Sam.”

That’s right, Uncle Sam. The good ole U.S.A. Now, most people don’t think of the U.S. government as their friend, but most people are not real estate investors. If you are. You know how to treat Uncle Sam right, he’s got some pretty terrific benefits in store for you.

When it comes to real estate taxes. We all know Uncle Sam has favored real estate investors in the past with generous real estate deductions and tax loopholes (many of which we will discuss in this article).

However, you may not know that some of these benefits just got super-sized under  the most recent tax reform . The super-sized benefits include bonus depreciation, more ways to defer taxes. Partial tax-free income for all sorts of real estate investors’ income. 

The Investor’s Guide to Real Estate Taxes

This post is going to dive deep (and I mean . deep. Over 3,000 words) into the benefits of real estate taxes you’ll get to enjoy as an investor. But first, the obligatory disclaimer: I am not a CPA. I’m also not a lawyer, doctor, or your mother. I’m a .

monkey in a room , frantically typing out words on a keyboard trying to produce Shakespeare. This facts, while I’ve spent hours and hours researching, is still just my opinion on what I’ve learned. Please consult with a vetted (and real estate-savvy) accountant before making any choices.

 That said, I did work with Amanda Han from Keystone CPA (my real estate tax CPA) on this article to make sure my know of real estate taxes was legit. If you need a CPA for your business, I highly recommend Keystone CPA. They do all my taxes. My tax-life has become about a thousand times easier since I hired them.

Now that we’ve got that out of the way, let’s get into this beast-of-a-post. Extra brownie points for those who make it through the whole thing. And to help, I’ve hidden a secret message in the text that will lead you to my buried treasure on a Caribbean island.

(OK, that’s a lie. But for those who seek to truly know the benefit of real estate taxes, incredible treasures ARE in store for you. This is because they won’t be in Uncle Sam’s pocket!)

Let’s get to the list. We’ll start out with the most obvious one: deductions.

As a rental site owner, you are able to deduct nearly all the expenses you’ll pay to manage your site. Everything from the mortgage interest you pay on the loan all the way down to the paper you buy for your printer (if you are using that printer primarily for real estate investing purposes, that is).

Of course, I’m not sure I’d necessarily qualify this as a “huge benefit” of rental site investing. This is because you are still having to spend the money on those items.

Who cares if you can deduct the cost of paper. This is because you own a rental site? If you didn’t have the rental, you wouldn’t have had to spend money on the paper in the first place.

However, where this deduction can come in handy are in the areas of your life that are shared with non-real estate tasks. For case, if you have a home office, you may be able to deduct a portion of your home expenses (fax machine, internet bill, cell phone bill, mortgage interest, home repairs, etc.) equal to the portion that your office takes up in your house.

Things like meals, travel. Other similar expenses may also be able to be deducted. Still, don’t assume you can go to Disney World with your family and write off the whole trip. This is because you spent a few hours looking at real estate.

That’s called “cheating,” and you’ll likely find yourself in some hot water if you ever get audited. However, just like your home office deduction, perhaps you can deduct a portion of your expenses to help offset the costs some.

Obviously. And I’ll say this numerous times in this post. Talk to your CPA about what you can and cannot deduct.

Cash gains are the profits you make. When you sell a site (that’s a very simplistic term. Still, it will work for our discussion). When you sell a site and make a gain, the IRS is going to want their share. However, that profit is taxed in one of two ways:

Short-term cash gains are gains made while holding the asset for one year or less. Also, long-term cash gains are gains made while holding the asset for over one year.

As a rental site owner, it’s most likely you’ll have owned the site for longer than a year, so you’ll most likely only need to pay the long-term cash gains tax. This can be much more favorable than the short-term tax.

 Currently, there is not special tax treatment for short-term cash gains, so you’ll simply be in charge for paying tax at whatever your regular IRS-defined tax bracket is based on your income. For case, in 2019, ordinary tax rates range from 10% to 37% , depending on how much total taxable income you received during the year.

On the other hand, in this same year, the long-term cash gains tax is either 0%, 15%, or 20%, depending on what income tax bracket you are in.

As you can see in the chart below, most married couples filing jointly in the 10% and 12% income tax brackets can pay 0% taxes on some or all of their in long-term cash gains. Also, those in the higher income brackets of 35-37% pay no more than 20% in long term cash gains, with most paying only 15%.

In other words, let’s just say last year your neighbor made $60,000 per year as a self-employed business owner. You also earned $60,000, but $40,000 of your income came from rents and the other $20,000 came from a site you sold. Your neighbor’s $60,000 was taxed at 22%. Still, he also had to pay 15% in self-employment tax .

You, on the other hand, paid $0 in taxes on the $20,000 in cash gains and no self-employment tax on any of your income. The only tax due was your 12% income tax on the $40,000 in rental income.

Still, with all the deductions (like depreciation, home office, car. Travel expenses). And possibly the Section 199A 20% Pass-Through Deduction. You ended up paying next to nothing. Also, your neighbor lost almost a third of his income to the IRS.

Same income amount, far other tax treatments due to real estate taxes.

Man, it feels good to be a real estate investor.

One of the deductions you’ll be able to claim on your real estate taxes each year is so powerful it deserves its own section here!

Depreciation is a deduction taken on materials that break down, but not all in one year. It’s not a concept unique to real estate. Still, is used in most businesses in America. To know the concept, let me try to explain it in more detail.

Let’s pretend you own an office supply store and you need to purchase a new $5,000 printer for your business.. This is because the printer is a business expense, the IRS allows you to deduct or “write off” the cost of the printer.

However, the IRS knows that the printer is going to last more than one year, so they don’t want you to write off the entire cost of the printer in the year you bought it. That would be too easy.

Instead, you have to spread out the deduction over the life of the printer, as defined by the IRS in . Publication 946, Appendix B.

(In this case, the IRS says a printer is depreciable over five years.) So, you could deduct a portion of the $5,000 the first year, another portion the second year. So on until you depreciate the entire printer. You are still getting to deduct the total cost, but you must do so over time.

Some years, like this year (2019), the IRS allows you to deduct the entire expense of gear like that printer we are talking about. Instead of needing that you deduct over a period of five years, they let you deduct it all at once in the current year, taking advantage of something commonly referred to as “bonus depreciation.” Even better, right?

Qualifications for this “bonus depreciation” vary by year and by person type of gear, so be sure to consult with your CPA for specifics on real estate taxes.

Make sense so far?

Now, housing real estate is also an asset that breaks down over time, right? The roof is failing, the siding is degrading, the wood is slowly decaying.

As such, the IRS allows real estate investors to deduct the cost of the building just like you might deduct a printer. (Notice that I said “building”. Not land. Land doesn’t break down over time. Even the IRS is smart enough to know that one!)

The IRS has determined that the deductible life of a piece of housing real estate is 27.5 years. For commercial real estate, it is 39 years. In other words, as a rental site owner, you are able to deduct the value of your building over that length of time.

“But my site isn’t going to disappear in 27.5 years!” you exclaim.

And you are right. This is why depreciation may be a benefit to you, the landlord. We all know that site values often go up over time. Anything that breaks down on the site we are able to deduct separately anyway. Therefore, depreciation on real estate is often known as a “phantom deduction”. This is because although we deduct the cost, the actual loss never really occurs.

Let me illustrate a quick case involving real estate. Let’s just say you bought a house for $100,000. You have determined (probably using the ratio between land and building defined by your county appraiser) that the building itself makes up 85% of the value of that site, or $85,000.

The land makes up 15%, or $15,000. Only the $85,000, therefore, is depreciable. Now, that $85,000 will be spread out over 27.5 years, so we simply divide $85,000 by 27.5 to get:

Therefore, we are able to “deduct” $3,091.00 each single year for the next 27.5 years on the site. Now, how does this come in handy?

Well, let’s say that your rental house produced $250 per month in cash flow for you after all the income and expenses have been calculated. Normally, as an investor, you would need to pay taxes on that income because, of course, it . is  income. That cash is what’s left over in your rental business.

But. This is because of depreciation on the site, you won’t pay . any  taxes on that (yet). That $250 per month works out to $3,000 in income over the year. Still, once you deduct the depreciation expense of $3,091 per year, you find that. On paper. You actually LOST $91 on your rental site.

This is what is known as a “paper loss” because, of course, on paper it looks like you lost money. Still, in reality, you made money. Try doing that with your W-2 job. It’s not going to happen.

Now, that was a small case of depreciation on a single-family house. Think of what could happen as you grow your group. Imagine if you owned $2,000,000 worth of real estate, and, let’s say, 85% of that is depreciable.

Now you are looking at $61,818 per year in deductions on the income you make from those sites, even though you never actually experienced that loss.

Does that seem too good to be true?

Well, it is. Sort of.

As much as I want to believe that the IRS is my friend and we could hang out together, grab some drinks. Talk about life, that’s not entirely true.

The IRS is out to get all the money it deserves, and, as such, the piper may still need to get paid. This is usually done when the real estate site is sold.

That’s right: All that money you “deducted” over the years of owning the rental site may be paid back to the IRS in a step known as “recapture of depreciation.” Currently, that amount is taxed at a hefty 25%.

Perhaps the best way to explain this is by using an case.

Let’s go back to that same case we talked about earlier with the $100,000 house, depreciated at $3,091 per year. If we owned the site for 10 years, we would have deducted $30,910 in total during those years and not had to pay taxes on that amount.

However,. When we sold, that $30,910 may be taxed at a 25% rate, in addition to any other cash gains taxes you would need to pay with the sale.

What a lot of people may not know is that depreciation recapture is only local to the extent that you had gain on the sale of the site. Lets say, for case, that we sold this site for a gain on $20,000.

In this scenario, even though we have taken $30,910 in depreciation, we may only need to pay recapture taxes on $20,000. This is sort of a perk that the IRS gives us by saying, “Hey, if you didn’t make money, then we’ll just let you have that old depreciation free of charge.”

Depreciation doesn’t seem so great after all, does it? And if you’re thinking, “Well, I just won’t take the depreciation on my taxes,” think again.

The IRS may need a person to pay that 25% recapture of depreciation charge no matter what, whether or not you took the depreciation. So, of course, you better take the depreciation or you’ll be paying taxes twice to the IRS.

Let me end with three points of consolation about this recapture of depreciation:

Well, since we touched on the 1031 exchange, let’s talk about that next.

The 1031 exchange is a legal plan used by many savvy real estate investors to bypass that whole “paying taxes” thing. When they sell. Named after the IRS tax code that brought the exchange into existence (Section 1031), the 1031 exchange allows an person to sell an asset and carry their basis forward into a new, higher priced site.

In other words, a real estate investor can use this tax code to sell a site and use the profit to buy a new one. And kick the can down the road and defer paying real estate taxes until that next site is sold (unless, of course, they use another 1031 exchange).

I know, that’s confusing. Let me explain it with a story.

John has owned a duplex for several years. Over time, the site has gone up in value considerably. He purchased the site for just $75,000, but today it’s worth almost $200,000. If he were to sell, he’d likely be stuck with paying a long-term cash gains tax on all that sweet profit, as well as the recapture of depreciation.

If his long-term cash gains tax rate was 15% and his profit was $125,000, that’s $18,750 directly to the IRS for the cash gains tax and potentially another several thousands dollars for the “recapture of depreciation.” But not if he uses a 1031 exchange.

John instead takes that money in profit and uses it as a down payment on another site. A $1,000,000 unit complex..

This is because he didn’t have to pay that $18,750 to the government, John was able to use it as part of his 20% down payment. This lets him to afford to buy another $93,750 worth of site (because 20% of $93,750 is $18,750).

Imagine if five years later John does the same plan again, and again, and again. He could keep to invest in increasingly expensive sites, growing his net worth without needing to fork over money to the IRS each time. Thanks, real estate taxes.

Of course, the IRS has some pretty strict rules that govern the 1031 exchange. These rules . must  be followed strictly, or the investor may lose the entire benefit and be forced to pay the tax. These rules are:

As you can see, these rules may make it difficult to properly carry out a 1031 exchange. This is true when good deals are hard to find. There is no sense in buying a terrible site just. This is because you want to avoid paying a 15% tax on your profit.

For this reason, some investors simply pay the tax and avoid the 1031. But for those who are willing to take on the government’s “1031 exchange hurdle,” faster growth and larger profits can result.

In 2019, a new benefit for real estate taxes known as the Option Zone gives an alternative to the 1031 exchange that also allows a taxpayer to defer cash gains taxes on the sale of a site. In addition to tax-deferrals, the Option Zone site may also give you with tax-free growth if the site is held over a 10-year period.

Why would the IRS give this tax benefit to investors? Well, it is an effort by the government to incentivize investors to revitalize certain areas within the U.S. market where housing upgrades are needed. 

Another tax benefit of investing in rental sites is that the income you received is not often taxed as “earned income” and therefore not subject to a major tax most Americans pay: the FICA/self-employment tax. This helps to fund Social Safe and Medicare.

FICA (short for Federal Plan Contributions Act) is a term that you’ve likely seen on your pay stub if you have a W-2 job. This is a 15.3% tax that is split 50/50 between the employer and the employee. Of course, if you are self-employed and have no employer, you are in charge for the full 15.3%.

This is known as self-employment tax. As you know, 15.3% is no laughing matter. Still, luckily for real estate investors, we have something to laugh at! The U.S. government does not currently look at rental real estate as a job or self-employed business. That way, tax is often not due.

Keep in mind, however, that this may depend on how you legally structure your real estate holdings. Certain plans, like holding sites in a C corporation and paying yourself a salary or paying yourself a care fee, could trigger the FICA tax, so check with your CPA to make sure you are optimized for the best tax treatment.

Next, let’s talk about one of my favorite benefits of real estate taxes for investors: tax-free borrowing!

Imagine with me that you own a piece of real estate worth $200,000. Still, you only owe $100,000 on that site. You could potentially take out a line of credit on that site OR refinance the site to pull out your equity.

So, let’s just say we went to the bank and refinanced that site for $160,000, obtaining a brand-new loan and paying off of the old one. After paying the original $100,000 loan off, we have $60,000 left over to do pretty much whatever we want with.

The best part is, although this is cash in your pocket that you just pulled out of thin air, you don’t need to pay taxes on this. Of course, this makes sense since you didn’t actually sell anything. But it’s not often you can get a big chunk of money and not pay taxes.

Sure, you’ll need to pay taxes someday. When you sell the site. Still, you can use that money right now with no tax at all. Use it to buy more rentals, lend to other investors, or take a trip to Fiji. It’s your money, do what you want. Tax-free.

Even better, if the proceeds from the refinance was used to improve your primary home or for another asset site, you may be able to deduct the interest paid on that loan! So, not only can you borrow the money tax-free. Still, you can possibly lessen your tax bill at the end of the year for doing so.

Taxes (and real estate taxes) are inevitable, as is death. But the IRS actually seems to like real estate investors, unlike the rest of the working world, so the sting is not quite as sharp.

The U.S. tax code is incredibly complex. Each plan has rules that must be followed, exemptions that are allowed, loopholes that only the rich seem to know about. Penalties if not performed correctly.

For this reason, it is absolutely imperative that you talk with an investor-savvy CPA about real estate taxes. When plotting your tax plan. I’ve been investing for almost 10 years now and still barely know the concepts I just tried to explain to you. You cannot do this on your own. You need help.

And remember, as you build wealth, a good CPA versed in real estate taxes will save you more money than they cost.