Many real estate investors seek ways to retain more income from rental or flip properties and one way to boost income is to reduce tax liability. At present, there are numerous, perfectly legal, tax loopholes that investors can use to cut tax bills. Here are six of the most popular strategies for trimming real estate taxes.
Make a flip property your primary residence for two years.
Real estate investors pay capital gains taxes on flip profits, either at the ordinary income rate (for properties held less than one year) or at the lower long-term capital gains rate (for properties held more than one year). If the property’s sale price is sufficiently low, investors could end up with more tax than profit. Fortunately for investors, there is a loophole that eliminates the need to pay capital gains taxes on a flip property. This strategy entails making the flip property your primary residence for at least two years. US tax laws allow individuals to sell a property without paying taxes on up to $250,000 of profits (double that amount for married couples) if the home has been their primary residence for at least two of the past five years. This tax loophole is particularly appealing for fix-and-flip investors who want to grow equity and also trade up to a better residence every few years.
Swap properties through a 1031 exchange.
A 1031 exchange enables investors to defer capital gains taxes on a property sale by immediately re-investing the sale proceeds into another property. Investors can utilize this tool to leverage capital and stay continually invested. There are four conditions that must be met to successfully execute a 1031 exchange:
- The exchange must involve a “like-kind” property. The IRS has a fairly broad definition of like-kind property. Almost any kind of real estate can be exchanged. For example, a single-family home can be swapped for a multi-family dwelling, an office building or even undeveloped land. However, 1031 exchange rules prohibit re-investing the proceeds from a property sale into a different type of asset such as a REIT. Another restriction is that the investor’s primary residence cannot be included as part of the 1031 exchange.
- The market value of the new property must equal or exceed the value of the old property. Any leftover funds would be considered profit and taxed at the capital gains rate. The good news is that investors can roll many costs associated with the purchase of the new property (i.e. inspection costs, broker fees, etc.) into its purchase price. Investors may also set up the 1031 exchange as a construction improvement exchange whereby a renovation loan becomes included in the purchase price of the new property.
- Property to be purchased must be identified within 45 days of selling. The IRS allows investors 180 days to close on the purchase of a new property, but requires that a replacement property be identified within 45 days of the close of the sale.
- Exchange must be handled by a qualified intermediary. The IRS doesn’t allow Investors to handle either the sale proceeds or the purchase transaction. Instead, a 1031 exchange must be conducted through a “qualified intermediary”. This intermediary can’t be a related party (such as a family member or business partner) or an agent who has provided services to the investor within the last two years (such as a current accountant, attorney or real estate broker).
Borrow against home equity.
Real estate investors who have substantial equity in a property may be able to increase wealth by re-financing a property and drawing out equity that can be used for other investments. In most cases, the borrower is allowed to pull out up to 80% of a property’s market value minus the existing loan. For example, on a $300,000 property with a $100,000 loan, the borrower may gain access to as much as $140,000 for reinvestment (i.e. 80% of $300,000 minus $100,000). Other factors impacting the loan amount include the investor’s credit score and debt-to-equity ratio.
Real estate investors may deduct depreciation as an expense, plus any capital improvements that have been made to the property, over its depreciable life. The IRS defines a depreciable life of 27.5 years for residential properties and 39 years for commercial properties. Investors should note, however, that only the value of the improvements to the land is depreciable, not the land itself. Another caveat when calculating depreciation expense is that repairs and capital improvements must be handled differently. Capital improvements may be depreciated over many years. Repairs must be deducted in the same year in which the expense is incurred.
Put properties to work immediately.
Investors holding a fix-and-flip property may reduce their tax liability by putting the property to work immediately. Even if your eventual goal is flipping, renting out the property in the interim may allow repair costs and depreciation expense to be deducted sooner and reduce capital gains taxes down the road.
Part-time real estate investors are permitted to deduct business losses less than or equal to their income, while full-time investors in rental properties may deduct losses that exceed their income. To take advantage of this tax benefit, investors must be able to prove rental properties are their livelihood.
The best starting point for maximizing your tax deductions is to track all property expenses carefully. It’s also advisable to discuss your situation with a tax professional that specializes in real estate. A trained specialist can help you navigate the complex maze of real estate tax laws and ensure you get all of the deductions you deserve.