The Tax Benefits of Real Estate Investing
It is surprising that many savvy investors are unaware of the fantastic tax advantages afforded to those who invest in real estate. Concepts like “tax-deferred investments” and “depreciation” are unfamiliar to many. In this article, we will examine how real estate investors can utilize US tax laws to secure long-term, exponential, tax-deferred growth in real estate.
What is a Tax-Deferred Investment?
When a person invests in the stock market directly through a taxable account, dividends and capital gains are taxed every year, decreasing the investor’s net returns. This is an example of a non-tax-deferred investment.
Investments in tax-deferred investments accumulate earnings tax-free until they are distributed. Examples of these tax-deferred investments include retirement accounts: 401(k), 403(b) and IRAs. By rolling over retirement funds into a self-directed IRA, it is possible to grow retirement funds in private real estate investments, tax-free, until retirement as well. However, the tax benefits of investing in private real estate are most applicable when using taxable funds because of the depreciation rules for real estate.
What is Depreciation? How Can it Result in Significant Tax Savings?
Depreciation is the loss in value of a building over time due to age and normal wear and deterioration. It can include land improvements an owner has made, and items inside the property that are not part of the building, like appliances and carpeting.
Rental property depreciation allows investors to write off the structure and improvements to the property over a period of time. This is a “paper loss” that you can use as a write-off on your taxes. However, you can only depreciate the improvements to the structure itself - not the land.
Depreciation is one of the biggest benefits to real estate investing because it can reduce reportable net income and, therefore, your taxes.
Depreciation at Work: An Example
The IRS allows owners to take a tax deduction based on the perceived decrease in the value of the property over a defined period of time.
Depreciation deductions are spread out over the “useful life” of a property. The IRS allows an owner to depreciate the value of the property over 27.5 years. Depreciation is calculated with this formula:
Cost of the Building - Value of the Land = Building Value
Building Value / 27.5 yrs = Yearly allowable depreciation deduction
It would look like this for a property worth $7,000,000 and land worth $1,500,000:
$7,000,000 – $1,500,000 = $5,500,000
$5,500,000 / 27.5 = $200,000
In essence, every year that you own a commercial real estate property, you’d be able to deduct $200,000! This yearly paper write-off is what allows the average investor to not pay any tax on annual dividends received by them for the first several years of property ownership. And for those who want to defer those taxes even longer, they simply buy more real estate. Because depreciation schedules can be combined, it is possible to defer taxes on investment income for decades! By investing in commercial multifamily real estate, you’re earning passive income with equity growth potential and outstanding tax advantages. We think that’s a pretty good deal!