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 applicable capital gain tax rate of 0%, 15%, or 20%, depending on income. However, for some upper income taxpayers ($250,000 for married filing jointly, $200,000 for single and head of household), there may also be a 3.8% Medicare tax for some or all of the gain, but only that part of the gain that exceeds the home sale exclusion, for a maximum total tax rate of 23.8%. Note that these tax rates apply only if the home was held for at least 1 year; otherwise, the short-term rate equal to the taxpayer's marginal tax rate on ordinary income will apply.
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 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 not requiring 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.
The New Tax Law Gives Rental Property Owners Several Tax Advantages and a Disadvantage
The new tax law, Tax Cuts and Jobs Act (TCJA), gives property owners several tax benefits. The new law expands tax brackets, so that the long-term capital gains rate of 0%, 15%, and 20% — have higher limits. The 15% bracket has a much higher limit, going from $418,400 in 2017 to $500,000 in 2018 for a single taxpayer. Thus, more wealthy Americans can avoid the top long-term capital gains rate of 20%
The depreciation deduction will continue to be especially advantageous for wealthy people, since they can write off the depreciation against higher marginal rates of tax — 32%, and 35%, and 37% — but when the seller sells the property, the depreciation is recaptured at a maximum rate of 25%. So the Donald J Trump's of the world can write off more than what they must repay later as recaptured depreciation.
Although the TCJA imposes new limits on deducting mortgage interest on a personal residence, and state and property taxes, including other local taxes, those limitations only apply to property for personal use. If there is any personal use of the property, then the limitations may apply to the portion allocable to personal use.
The TCJA also allows a new qualified business income deduction equal to 20% of qualified business income (QBI) from a pass-through business entity, which includes sole proprietorships, as well as the usual pass-through business entities, such as limited liability companies and S corporations. However, the QBI deduction is restricted at higher income levels and limited to taxable income.
However, as of April 2018, it is not clear whether a rental real estate activity counts as a business in regards to the QBI deduction. This aspect must be clarified by the IRS, when they publish the detailed rules.
Additionally, an expanded use of the §179 deduction is increased to $1 million, starting in 2018, and the deduction can be applied to property improvements for property placed in service after 2017 and if the improvements were made after the building was put to use.
Eligible property includes depreciable tangible personal property used to provide lodging, such as furniture, appliances, and other equipment installed in the living quarters of the lodging facility, such as an apartment or dormitory. However, the §179 deduction cannot be used to create or increase a loss from business activities.
A first-year bonus depreciation of up to 100%, increased from 50%, can also be applied to eligible property placed in service after 2017 but before 2023. The deduction can be applied to leasehold improvement property, retail improvement property, or restaurant property.
For tax years 2018 through 2025, an excess business loss, one that exceeds $250,000 or $500,000 if married filing jointly, cannot be deducted in the current year, but must be carried over to the next year, which then can be deducted under the net operating loss (NOL) rules for carryovers. This only applies if the loss is not limited by the passive activity loss (PAL) rules. The nondeductible loss is treated as an NOL carryover to subsequent years. This new loss limitation rule is to restrict using current year business losses from rental real estate to offset other sources of income, including salary, self-employment income, and investment income. So any current business year losses not limited by PAL rules cannot offset more than $250,000 of income from other sources or more than $500,000 if married filing jointly.
The TCJA does not change the tax treatment of §1031 exchanges, known as like-kind exchanges.
Revenue Procedure 2019-38 provides a safe harbor for some interests in rental real estate, including mixed-use property, to qualify for the QBID as a trade or business. The taxpayer or RPE must hold each interest directly or through an entity disregarded as an entity separate from its owner, such as a limited liability company with a single member.
To claim the safe harbor, these requirements must be satisfied:
- Separate books and records must be kept to reflect income and expenses for each rental real estate enterprise.
- For rental real estate enterprises existing for less than 4 years, taxpayers must provide at least 250 hours of rental services annually. For longer duration enterprises, at least 250 hours of rental services must have been performed in 3 of the past 5 years.
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, showing: hours, description, and dates of the services and who performed the services.
- The taxpayer or RPE attaches a statement asserting the use of the safe harbor to the tax return.
Owners of rental properties may still claim the QBID even if all requirements of the safe harbor are not satisfied, as long as the business would otherwise qualify under IRC §199A.