Real Estate Tax Benefits
There are many tax advantages to owning real estate:
- capital gains taxes can be excluded or deferred
- depreciation of property used in an investment or a business can defer some income taxes
- interest expenses on a mortgage on a primary or secondary home and home equity loans can be deducted
Home Sale Exclusion
If you live in a residence for at least 2 years in the 5-year period before selling the property, up to $250,000 worth of capital gain can be excluded from income ($500,000 for a married couple filing jointly). This home sale exclusion may also apply to vacation property, if certain tax rules are satisfied. You can take advantage of the home sale exclusion every 2 years, so it can be an effective way to increase your wealth, especially if you know how to do home-improvements. Any gains not covered by the home sale exclusion will be subject to the lesser of your marginal tax bracket or 25%, since the maximum capital gain tax rate on real estate is 25%. However, for some upper income taxpayers, there will also be a 3.8% Medicare tax, for a total tax of 28.8%.
Deducting Interest Expenses
The interest incurred on a mortgage used to buy a 1st or 2nd home or to improve those properties is deductible as an itemized expense. Interest incurred on money used for other purposes is not deductible unless used for investments or property improvements. Credit card interest can be deducted if the principal is used to improve rental property or for rental operating expenses. More: Itemized Deductions For Interest Expenses on Home Mortgages and Home Equity Loans
Depreciation is a major tax advantage for real estate, allowing the deferral of taxes on income earned by the property. The amount that can be depreciated depends on the value of the structures on the land and the type of structure. Land itself cannot be depreciated, since it does not wear out. The class life for residential real estate is 27.5 years, for commercial real estate, 39 years.
Unlike most other expenses, the depreciation expense is solely a tax write-off; it does not require an actual payment of cash. Depreciation helps to shelter some of the income earned from the property from taxes.
When real estate is ultimately sold, then a capital gain may be realized on the property, equal to the sales price minus selling costs minus the adjusted basis of the property. The tax basis for real estate is = to the original purchase price + closing costs + any capital improvements. Because the tax basis often changes, especially for real estate, it is often referred to as the adjusted basis. However, taxes on the deferred depreciation must be paid as recaptured depreciation, reported separately on the return, equal to the lesser of the taxpayer’s marginal tax rate or 25%.
However, depreciation can only be claimed on investment or business property until the sooner of the end of the depreciation period or when the adjusted basis is reduced to 0. Personal-use property, such as a home, is not depreciable, although a portion of those expenses may be deductible if the home has a home office.
Home Office Deductions
Home office expenses can be deducted as business expenses if an area of the home is used exclusively for business. Business expense deductions save on both the marginal income tax and self-employment taxes for the self-employed. A portion of the expenses for the entire home is deductible, with the portion equal to the area of the office divided by the area of the entire home multiplied by the expense. So, the business portion of mortgage interest, home insurance, and real estate taxes can be deducted. Additionally, any expenses that pertain only to the home office are fully deductible.
An employee can also claim home office expenses, but only if the office is maintained as a convenience to the employer. As miscellaneous expenses, only expenses exceeding 2% of the employee's adjusted gross income are deductible and they do not reduce employment taxes.
Rental Income and Expenses
Income from real estate is considered passive income, so any losses can only be deducted from other passive income. At-risk rules may also limit deductions, since claimed deductions cannot exceed the amount at risk. However, there is a tax break for people who earn $100,000 or less. If you actively manage the property, meaning that you make decisions about any improvements or alterations or select tenants, then up to $25,000 of losses can be used to reduce nonpassive investment income or active income, earned income from work. Even if you hire a property manager, you can still qualify as an active investor if you make some of the decisions regarding your property. For incomes exceeding $100,000, the $25,000 allowance is reduced by $.50 for each dollar over $100,000, thus phasing out completely at $150,000 of income.
Rental income and expenses are reported on Schedule E, Supplemental Income and Losses of the federal tax return. Expenses necessary to manage rentals include:
- real estate taxes
- maintenance expenses
- management expenses paid to a property manager
- traveling expenses, such as those incurred for showing vacant properties or repairing properties
- legal and accounting expenses
- interest expenses, including the interest on mortgages and on other debt incurred to operate or repair the property
- advertising expenses, including the cost of creating and maintaining websites
- signage costs
- referral fees
- insurance premiums for insuring the property against damage and liability
- any educational expenses, incurred to learn about property management or rental management
Although property taxes are generally deductible, special assessments for neighborhood improvements will generally have to be either depreciated or added to the adjusted basis of the land.
Depreciation is also a major deduction. The tax code allows the depreciation of residential structures over a period of 27.5 years; commercial property, 39 years. Only investment or business property can be depreciated. So, if you own residential property with a tax basis of $275,000, then $275,000 ÷ 27.5 = $10,000 can be deducted each year.
Any expense incurred to improve property or that extends the lifetime of the property must be capitalized rather than deducted, meaning that the cost is added to your tax basis of the property. Taxes are saved through depreciation of the increased tax basis of the property or when the property is sold, since profits will be reduced by the amount of the capital expenditures. Capital improvements include any repair or alterations of the structure of the house, such as flooring or roofs, and heating and air-conditioning units.
Tax credits may also be available for certain types of expenses, such as the construction of low-income housing, building modifications that satisfy the Americans with Disabilities Act (ADA), and the renovation of certain historical buildings considered historically significant.
Additionally, there are several tax credits related to energy-saving improvements for the home, discussed in more detail here: Residential Energy Credits.
If a vacation home is rented for fewer than 15 days, then the income does not need to be reported, but neither can any expenses be deducted. If personal use of the home exceeds the greater of 14 days or 10% of the number of days the property was rented out, then rental expenses can only be deducted to the extent of rental income, and any net income is taxable. If personal use is less than the 14-day/10% threshold, then any net losses can be deducted against other income, such as wages or business income.
Property taxes are ad valorem taxes assessed annually on property. The tax rate is applied to the value of the property or a certain percentage thereof, such as 50% or 80%. So if a property is assessed at $100,000 and the property tax percentage is 80% of assessed value, then the tax rate will be applied to $80,000.
There are several methods of possibly lowering property taxes
- Check if the assessed value is accurate.
- Is the purchase price comparable to the assessment? An assessed value higher than a recent purchase price is a good indicator that the assessment is too high.
- Are there any negative aspects of the property compared to neighboring properties that might lower the value to less than what the neighbors are paying?
- Does the assessment conform to all the technical requirements of the law?
Additionally, the law may provide exemptions from part or all of the tax, such as the homestead exemption for people who live in their homes, senior citizens, blind people, military veterans, and low-income groups. Historical properties may also qualify for lower property taxes.
Moreover, a property owner can keep taxes lower by making only those home improvements that will not increase taxes, mostly improvements that do not require a building permit.
Deferring Capital Gains Taxes
Capital gains taxes can also be deferred. Real estate can be sold as an installment sale, allowing the capital gain tax to be prorated over the installment period. For instance, if property is sold with a $100,000 gain as an installment sale over a 5-year period, with $20,000 due on each year of the installment period, then only $20,000 of capital gain is recognized in each of those years. Without the installment sale, the capital gain tax on the entire $100,000 would be due in the year of the sale.
Tax-free exchanges may defer or even eliminate taxes on capital gains of real estate. If one property is exchanged for another, then the exchange can be tax-free if it is completed within 180 days and if it satisfies other tax rules. The new property will receive a carryover basis of the old property, so when the replacement property is ultimately sold, then capital gain will be recognized to the extent that the sale price of the replacement property exceeds the adjusted basis of the relinquished property. If you die before selling the relinquished property, then it receives a stepped-up basis in your estate, thereby eliminating any capital gains taxes on the property.
Tax-free exchanges can involve just the 2 parties exchanging the property, but more often, an intermediary is required to satisfy the time constraints in conducting the exchange.
Complete records of income and expenses for any claimed deductions should be kept. Typical expenses for an investment property include:
- repair and maintenance
- advertising costs
- attorney or property manager fees
- property taxes
Income and expense records should be kept for each investment property. When keeping receipts, identify the property for which the receipt pertains.
Another type of expense typically associated with investment properties are capital expenses, expenses that increase the value of the property or prolongs its useful life. However, capital expenses cannot be deducted currently, but must be added to the adjusted basis of the property, thereby saving on taxes when the property is sold. Hence, it is important to distinguish between current expenses and capital expenses. Current expenses are deductible in the year that they are incurred; capital expenses are deductible when the property is sold. So, repairing a broken window is a current expense while replacing a window with a thermal efficient window would be a capital expense. Any records for capital expenses should be kept at least 3 years after the final disposition of the property.