What Does An Investor Need To Know About The Tax Benefits of Real Estate Investing

Do you want to know if rental income counts as earned income & find out other questions about tax deductions? You’ve opened the right article then! We’re telling you here what taxes are deductible from your yearly income & how you can use them properly in various scenarios. We’re also doing some math to make it more understandable.

Important! When you’re reading the article, you should remember that all taxes & their filing are not as straightforward as we present & they are full on nuances & intricacies, mostly concerning conditions of application, applicable amounts of annual income & connected tax (at low & high ends), periodicity of taxation & filing & tiers of applying, as well as areas of applying (as you must already know that not all taxes are equal on the entire US territory, especially in its overseas regions). So in all cases, it is advisable to consult a tax attorney in your area, who knows the current data & can give you calculations & pieces of advice according to the current situation.

How rental property tax deductions work

The tax deductions we are speaking about here are connected to rental property deductions. That is, you shall be a landlord, who earns income from possessing a rental property or a land plot. It is considered a commercial property from the point of view of the IRS. And when you’re running one or more such businesses, in order to normalize the tax load on you & other landlords like you, making such a business model more lucrative for investors, IRS currently offers several types of tax deductions, which you can utilize to leave more cash on hand.

The items of your expenses for running a landlord business that you can deduct from your taxes as of 2021 in the US are:

• cost of maintenance, upgrades & repairs
• fees to a property management company (should you hire one) or the expenses for the organization & running of your manager office (should you establish it yourself)
• insurance for your commercial property
• mortgage interest (should you use a bank loan to finance your purchase)
• property taxes.

Let’s say you have an object of $500,000 cost, which has 10 one-family apartments, every one of which generates you $550 rental income per month. Additional gains from rentals are $5,000 annually (for extra services like carpet cleaning, room service, laundry, parking, etc.). Annually, thus, you earn $71,000. And you have operating expenses equal to $30,000, which leaves you with $41,000 pure income. Of those 30 thousand, you have the so-called ‘qualified expenses’ of $15,000. They would include advertising, fees for an attorney & accountant, office space, business equipment, work travel, education, improvements connected to energy efficiency, dues you pay for being in some official homeowner’s association, professional subscriptions & more. Thus, you can deduct these $15,000 from your annual taxable income, which will make it 71-15=$56,000.

Needless to say, you have to meticulously keep all records, documents, contracts & receipts that prove those qualified expenses in the case if you’re audited by the IRS.

Tax benefits of rental property counted & considered one by one

Now let’s look at the list of other rental properties taxes deductions, which you can also use in your business.

Depreciation.

Alternatively known as ‘amortization’, depreciation is how your entire commercial property gets depreciated from 100% to 0% of its cost from the point of view of accounting. The IRS establishes various times for depreciation, which is 27.5 years for residential properties (usually understood as premises, where a person or family regularly lives & does not let it for lease) & 39 years for commercial objects. Your object of $0.5 million will be depreciated in 39 years, each year for $12,820.51, which is tax-deductible.

Surely, from the market point of view, your property doesn’t go anywhere after it’s been used for 39 years – you can still sell it, in most cases, even for a bigger price you have bought it.

Also, what you invest in maintaining your property (a.k.a. general improvements) is also depreciated but in other terms that sounded – some improvements may have 1 year, some 5 or other terms. Consult with your tax attorney for exact numbers of rental property tax deductions. These improvements would include rebuilding a place, changing the leaky roof, adding more rooms or storeys, making a parking lot instead of lawn, changing floors & other expenses, which configure the condition & cost of the real estate.

Pass-through deduction.

You can deduct up to 20% of your qualified business income from your personal taxes. And you don’t have to be a sole proprietor of the object – you can also own it through partnership, S Corp, or LLC. This perk (enacted by the Tax Cut & Jobs Act of 2017) will cease to exist in 2025, so you should hurry up deciding on owning your first property to use it (if you still aren’t). Thus, given the example numbers above, your rental income is $56,000 & you can deduct $14,200 annually (this scheme presupposes the lowering of the annual income for the annual qualified expenses).

Capital gains.

There are 2 types of them: short-term & long-term. The first occurs if you own a property for less than 1 year & 1 day before selling it. In this case, taxes paid are high – they’re counted as a regular income & account from 10% to 37% (depending on the particular amount of yearly gross income). In the second case, the taxes are lower & account from 0% to 20%. If your annual income isn’t going over some defined threshold, you may not pay any income tax at all, which is a point of high interest for many landlords. For instance, your spouse & you together make below $75,000 a year (let’s say, the entire revenue you both have is the one you get from renting a property). Then your long-term capital gain tax is 0%. Logically, you might be interested in holding a low-profit real estate object for a longer time than 1 year & 1 day before selling it to save on the capital gain tax – but that won’t matter if you sell it for the lower or same cost.

1031 Exchange.

This tax incentive was put in place by the government to encourage landlords to buy & own new properties after they sell old ones. The cost of a new one should be the same or more than the one, you’ve sold. So if you’re not cashing out the money from the sale, you pay 0% tax under the 1031 incentive. From the taxation point of view, you simply swap the properties. But it’s a complicated program with many conditions & tiers, so you should better consult a tax attorney.

Opportunity zones.

Some US territories are defined as the ‘opportunity zones’ – disadvantaged or low-income lands (defined by the Tax Cut & Jobs Act of 2017). If you’re one of the investors in such territories, which you can do by buying shares of the special fund, you can use this tax incentive to lower your taxes until 2026. Although you have slightly more than 4 years to enter the program, its benefits will apply for you for as long as you hold the share (before selling it). The milestones are 5, 7 & 10 years of owning. After reaching each milestone, you can deduct 10%, 15% & 100% of your long-term capital gains respectively. As this is also a tricky & complex incentive, we highly encourage you to consult a tax attorney.

No-FICA tax self-employed.

A.k.a. Payroll tax, this incentive allows you not to pay income tax when you’re working as a self-employed person while also being a landlord.

Let’s simplify the understanding: you are a freelance programmer who earns $60,000 a year. Normally, you have to pay 15.3% tax on personal income ($9,180 a year) & your employer portion of taxes – Medicare & Social Security. If you use the Payroll tax, you won’t have to pay the 15.3% tax for this earned income & you only pay the employer portion of taxes – for as long as you pay other taxes as a landlord. Although, in the combination with other tax deductibles, which you might want to use, this might not work in full or partial. For instance, when your gross annual income is bigger than a certain sum, you may not be eligible for exemption from the long-term capital gains on rental property tax.

Conclusion on rental property taxes

Now you know the answer to the question, does rental income count as earned income. And if you wisely & meticulously use all applicable provisions of current tax legislation, you may significantly optimize your annual tax expenses. Although some incentives end in 2025/2026, you still have years to enjoy the deductions legally. Finally, what you have to know is that being a landlord is tax-efficient in the US in the long run.