Explore the tax advantages of real estate investing
Taxes and landlords
- Mortgage interest deductions apply to rentals as well as personal residences.
- Expenses and repairs associated with rentals are tax deductible.
- Property improvements are not deductible.
- Rental income is exempt from federal Social Security and Medicaid taxes.
- Capital gains on property is taxed at a lower rate than income, and the taxes can often be deferred.
In addition to being a time-tested wealth-building technique, investing in residential income properties offers a number of tax advantages. Many of them are not available with other types of investing, or in short-term fix-and-flip real estate deals.
Before learning about some of the most common tax breaks for landlords, it's worth noting that individual circumstances can affect individual tax obligations, and it's always a good idea to get advice from a tax professional. Also, the Internal Revenue Service (IRS) summarizes some of the tax considerations that apply to residential property investment in its Publication 527, which is posted on the IRS website.
Mortgage interest payments and real estate taxes are deductible on investment property, just as they are for a personal residence. Landlords also can deduct the interest on loans used to improve rental properties, as well as interest on credit card purchases for rental-related activities.
Investors can claim a depreciation deduction on residential income property
Depreciation, as defined by the IRS, "is an allowance for the wear and tear, deterioration, or obsolescence" of property. Residential property — buildings, but not the land — are depreciated over a period of 27.5 years. (Divide the cost of the building by 27.5 to get the yearly deduction.) It's a valuable tax savings that allows landlords to depreciate the cost of their income property, even though the value of the property is presumably increasing over the years. The IRS outlines depreciation rules on its website, in its Publication 946.
Many rental-home expenses are tax deductible
Some of the most common deductible rental expenses, according to the IRS, including the following:
- Auto and travel expenses
- Cleaning and maintenance
- Legal and other professional fees
- Local transportation expenses
- Management fees
Deductible legal and professional fees include tax-return preparation charges. A transportation deduction applies for travel conducted to collect rental income or manage and maintain a property.
Repairs are deductible
Landlords should know the difference, under IRS regulations, between repairs and improvements. Expenses associated with keeping a rental property in good condition — painting, unclogging a drain, replacing a damaged electrical outlet, etc. — are considered repairs and are deductible. But anything that adds value to the property — a new kitchen or remodeled bathroom, for instance — is considered an improvement and is not deductible, although the cost of the improvement can be depreciated over time.
Landlords are not defined as self-employed
That’s according to IRS regulations, so the income they receive from rents is generally exempt from the federal FICA tax. That's no small consideration: Self-employed individuals pay 15.3 percent of their income in FICA tax, which is earmarked to help fund Social Security and Medicare. An individual's classification can change, depending on the corporate structure of the real estate holdings, so a tax professional's help is very important here. Also, high-income investors (married couples with adjusted gross incomes of more than $250,000, and single taxpayers with adjusted gross incomes of more than $200,000) are subject to a 3.8 percent Medicare investment-income tax surcharge.
Landlords can tap into the equity in their property tax free
That can be accomplished through cash-out refinances. If you own a $300,000 property, but only owe $100,000 on the mortgage, you can take out a new loan based on the current value, subject to bank-lending limits, and pocket the difference, tax free (minus refinancing costs). The loans are the same as cash-out refinances available for personal residences and include the mortgage-interest deduction. The refinancing technique can be a particularly attractive way for an investor to raise tax-free cash to buy additional properties.
Investors can avoid paying capital gains on the sale of residential investment property
If the seller rolls the money over into another real estate investment, there is no capital-gains tax due. Under such transactions, known as 1031 exchanges, or like-kind exchanges, investors can swap a property they want to sell for another similarly valued replacement property. The like-kind exchanges come with a great deal of latitude. A landlord can swap single-family rentals for apartments, or many other kinds of commercial properties, for example. Rental or commercial property, however, cannot be swapped for a personal residence, or vice versa.
Long-term owners of an income-property that sells for cash pay taxes at a lower rate
The profits earned from a cash sale involving real estate held over the long term are taxed at a lower rate than imposed on most earned income. For tax purposes, "long-term" is defined as having owned a property for a year or more. Properties sold after that point pay taxes at the federal capital-gains rate, which ranges from zero to 20 percent, depending on a taxpayer’s marital status and total adjusted gross income. Short-term real estate investors — fix-and-flip investors, for instance — are taxed on their profits at the higher earned-income rate.
There is a lot of tax information to absorb for investors and would-be investors, including the fact that states and even municipalities have their own twists and turns governing real estate income and capital-gains taxes.
As with any investment, there is never a guarantee that rental properties will be money-makers. They often do allow for substantial accumulation of wealth over time, however, and a dependable income stream — due, in part, to the favorable tax treatment of real estate investments.