There are many benefits to owning a rental property, and they offer an irresistible mix of cash flow and equity growth. The tax shelter, however, is by far the most attractive benefit. Because rental properties ride the line between being a business and being an investment, an investor will typically get tax advantages and liberal write-offs, including tax deferrals for rental properties that are exchanged.
Tax-sheltered Cash Flow
You are taxed only on profits you earned from your rental properties. To work out your profits, add all your rent and other income sources, then subtract all of your expenses. Your rental property expenses should include things such as property taxes, repairs, mortgage interest, and management fees. It can also include travel-related expenses. For example, if you own a rental property in another state and travel there mainly to work on it, your travel costs for those workdays may be deductible. Personal days and personal expenses on the trip are not.
Tax-sheltered Growth
Those who invest in real estate do so in hopes that their properties will increase in value every year. This happens through the monthly payments to the mortgage, which adds to the property’s equity ownership. Further growth can come from the increase in value, which may be the result of a healthy market, or due to a growing net operating income, which is the case for rental properties. Because the Internal Revenue Service doesn’t tax capital gains until the property is sold, the money will continue to grow.
Deductions On Passive Activity Loss
The number of expenses you can claim on an investment property will most likely end with a taxable loss. In many cases, you can’t invest and use losses from any passive activities to offset the income that you may earn from a job. The IRS, however, will let you claim as much as $25,000 in passive activity losses if you actively participate in managing the rental. To claim the full amount, your modified adjusted gross income must be $100,000 or below (whether you file single or married filing jointly). If you’re married filing separately and lived apart from your spouse all year, the limit is $12,500 and starts phasing out at $50,000. If your income is over the threshold, the allowance drops $1 for every $2 of income, and it phases out completely at $150,000 ($75,000 if married filing separately). Additionally, unallowed passive losses are carried forward and can offset passive income from any passive activity. When you sell a passive activity with passive losses, the carryover losses can all be taken in the year of the sale.
Tax-Deferred Exchanges
Investors can structure the sale of an investment property as a tax-deferred exchange, known as a 1031 exchange. For example, you may sell your rental property and use the money to buy further investment properties—even if it’s located in another state or is a different property type. Using the rules stated by the IRS, you can transfer your cost basis from an old property into a new one. When the exchange follows the IRS rules, including identifying the replacement property within 45 days and closing within 180 days, capital gains and depreciation recapture taxes are deferred rather than paid at the time of the exchange.
FAQ’s
What tax deductions can rental property owners typically claim?
Rental property owners may be able to deduct a variety of expenses related to operating and maintaining their investment properties. Common deductions include mortgage interest, property taxes, repairs, insurance, property management fees, advertising costs, and certain travel expenses directly related to managing the property. Investors should consult a qualified tax professional regarding their specific situation.
How does rental property depreciation benefit real estate investors?
Depreciation allows property owners to deduct a portion of a property’s value over time, which can reduce taxable income even when the property is generating positive cash flow. This tax advantage is one of the key reasons many investors choose rental real estate as a long-term wealth-building strategy.
What is a 1031 exchange and how can it help investors defer taxes?
A 1031 exchange allows eligible real estate investors to sell one investment property and reinvest the proceeds into another qualifying property while deferring certain capital gains taxes. When structured properly, this strategy can help investors grow their portfolios while postponing tax liabilities.
Can rental property losses reduce my taxable income?
In some cases, rental property owners may be able to use passive activity losses to offset other qualifying income, subject to IRS rules and income limitations. Any unused losses may be carried forward to future tax years, potentially providing additional tax benefits down the road.
Why do many investors consider rental real estate a tax-advantaged investment?
Rental properties offer multiple potential tax benefits, including deductible operating expenses, depreciation, tax-deferred exchanges, and opportunities to build equity while generating income. Combined with long-term appreciation potential, these advantages make rental real estate an attractive investment strategy for many property owners and investors.
About the Author
Christie Slatcher is the owner and CEO of Jamico Properties, a family-owned property management company that has looked after rental property in the South Bay and in Tulsa since 1995. Her team manages more than 2,400 units across both markets, from single rentals to multi-unit buildings. She writes from what actually comes up in the day to day, not from theory.
Jamico Properties, a DBA of Jamison Management Company. DRE #01356743.