There are plenty of tax benefits rental property owners can and should take advantage of.
Taxes constitute a very large portion of the expenses that rental property investors incur. Additionally, paying taxes is mandatory. So, there’s no way to evade paying them without breaking the law.
But, don’t stress about it. Yes, the taxes may be mandatory, but there are tricks that investors can use to minimize their tax obligations.
So, what are the tax benefits of investing in multi-family real estate? Well, read on to find out.
Tax Benefits of Multi-Family Real Estate Investing
Well, just like any other type of investment property, multi-family rentals come with their fair share of tax breaks. Knowing about each one could spell the difference between paying and saving thousands of dollars in taxes every year.
Generally, there are a number of tax breaks available for these types of properties; here are some of the most common types:
1. Real Estate Depreciation Tax
Arguably, depreciation is one of the biggest and best real estate tax shelters for rental property owners. Depreciation works on the principle that properties depreciate over time.
Therefore, the depreciation amount is a tax deduction that covers the property’s exhaustion or “wear and tear” over the years.
Now, you might be wondering how a property can decline while its value increases throughout time.
Well, the IRS treats properties like any other type of asset. Therefore, to them, the real estate’s quality diminishes progressively. Think about owning a car, it’s the same principle.
Although, in reality, it’s rare for that to happen. In fact, with proper maintenance and a growing neighborhood, the property’s value is bound to increase.
Therefore, regardless of whether the property is making profits or appreciating in value, owners can deduct a depreciation expense from their real estate income tax. Clearly, it’s evident that depreciation offers investors a massive tax break.
So, how does depreciation work?
According to the government, residential property is only useful or profitable for 27.5 years (39 years for commercial properties). Therefore, the IRS allows rental property owners to deduct a depreciation expense for that amount of time.
To calculate your property’s depreciation amount, all you have to do is to divide its worth by the number of years. Here is an example:
A multi-family property worth $500,000 would have a depreciation expense of $18,182 per year ($500,000/27.5). Let’s face it, deducting such an amount from your taxable income saves you a lot in taxes.
For instance, if the property above generates an income of $80,000 per year, your tax obligations would be:
- Taxes owed without depreciation = $80,000 x 25% (federal income tax) = $20,000
- Taxes owed with depreciation = ($80,000 – $18,182) x 25% = $15,455
Therefore, in such a scenario, the property owner gets to save $4,545 annually without including any other deductions. Amazing, right?
2. Real Estate Investment Tax Deductions
Another great way to lighten your tax burden is by taking advantage of tax deductions.
So, what are tax deductions? Basically, a deduction is an expense that’s written off from a rental property owner’s taxable income. The law allows you to deduct the expenses you incur to manage, maintain, and repair your multi-family property from your total taxable rental income.
Generally, this means that you can reduce your tax obligation by writing off expenses from your total taxable income. Some expenses are:
- Insurance premiums
- Management costs
- Maintenance and repair expenses
- Mortgage interest
- Marketing costs
Obviously, a smaller taxable income equals a smaller tax burden.
Another real estate taxation benefit is cost-segregation. Cost-segregation is similar to depreciation. The only difference is that it also involves the value depreciation of certain items in the multi-family rental property. For instance, items like cabinetry, fixtures, and appliances.
According to the IRS, these items have a shorter lifespan. That’s why they allow real estate investors to make depreciation expense write-offs on these items for a period of 7 years.
So, you are probably wondering how this works. Let’s look at an example:
Well, suppose your property is valued at $500,000 and comes fitted with appliances, fixtures, and cabinetry worth $100,000. Your total depreciation expense will be computed as follows:
- Value of the property = $500,000 – $100,000 = $400,000
- Depreciation expense for the property = $400,000/27.5 = $14,545
- Depreciation expense for the cabinetry, appliances, and fixtures = $100,000/7 = $14,286
- Total depreciation expense = $14,545 + $14,286 = $28,831
Amazing, isn’t it?
If you compare the depreciation expense with and without cost-segregation, you’ll note that cost segregation offers you a higher tax shelter. But, there is a catch.
Unfortunately, cost-segregation often affects your tax bill when you decide to sell the property. The more you use cost-segregation, the higher your tax bill will be when you sell the property.
4. 1031 Exchange Tax Benefits
Under section 1031 of the Internal Revenue Code, a property investor can swap their rental units with little or no capital gains tax obligations.
Unfortunately, for one to qualify for this tax benefit, they have to meet a few conditions. The following rules apply to 1031 exchanges:
- The new property must be equal or greater in value than the old one.
- The swapped property must be used for productive business purposes.
- Both properties have to be “like kind.”
5. Passive Income Tax Benefits
A real estate professional is anyone who spends more than 500 hours on real estate annually. A passive income tax benefit is yet another great tax break for investors and owners who aren’t “real estate professionals.”
If you spend less than 500 hours on your business, then you are obligated to pay passive income tax instead of normal income taxes. And when the property appreciates in value, you’ll pay capital gains taxes.
Generally, passive income and capital gains tax rates are lower than the federal income tax rates. This means that, if you aren’t a real estate professional, your multifamily real estate investment tax obligation will be much lower.
With these tax benefits, you can drastically reduce your tax burden. All it takes is a little research and proper tax strategies to make the most of all available tax breaks.