The goal of any real estate investor is to make as much money from their investment as possible. One way to accomplish this is by reducing some of the expenses associated with running your rental property.
Among the expenses on an income property owner’s list are taxes. As a landlord, you need to pay taxes on the money you receive from your tenants. Failure to do so can result in dealing with the Internal Revenue Service.
Luckily, the IRS provides a way to lessen your tax responsibilities. Between 1031 exchanges, depreciation, and other tax advantages, you can significantly lessen your tax burden. Consequently, this can land you one step closer to earning profit from your investment.
Tax Benefit #1: Depreciation
Real estate is often considered as “tax-advantaged” income, stemming from the depreciation factor. To have an income generating property, you have to buy a building and rent it out to tenants.
In turn, the tenants pay you rent every month. Owning the rental building requires that you pay certain operating expenses:
A) Property management fees
B) Mortgage payments
C) Property advertisement fees
An operating expense that’s often under the radar is property depreciation. Unlike other operating expenses, when you take depreciation, no cash comes out of your pocket.
What exactly is depreciation then?
It refers to the wear and tear or obsolescence of a property. Depreciation deductions are generally spread out over the useful life of a property.
Here’s an example that best explains how you can make use of depreciation to lessen your tax burden:
Suppose you earn $10,000 in rental income. Let’s also suppose that you have $7000 depreciation expense and have operating expenses amounting to $4,000. With these figures, it means that you have a net loss of $1,000 (10k – 7k – 4k).
What this means is that you aren’t paying anything on your rental income. It also signifies that you accumulated an income amounting to $6,000. This is the kind of power depreciation can have on your earnings.
Tax Benefit #2: Deductions
The IRS permits tax deductions for any legitimate expenses related to running a rental property. You can deduct property tax, accounting fees, repairs, mortgage interest, cleaning services, etc.
Here’s a couple of them:
- Legal and professional services. As long as the fees are paid for work related to your rental property, you can deduct fees that you pay to professionals such as real estate investment advisors, property management companies, accountants, and attorneys.
- Insurance. You can deduct the premiums you pay for almost any insurance related to your rental property. Good examples include landlord liability insurance, flood insurance, theft, and fire.
- Employees and independent contractors. Whether an independent contractor or a resident manager, you can deduct the wages of anyone you hire to perform services for your rental activity.
- Home office. Do you operate from your home? If so, then you may deduct your home office expenses from your property’s taxable income provided you meet certain minimum requirements.
- Travel. You can also make deductions on any driving you do for your rental activity. For example, when you head to the hardware store to buy a part for a repair or when you drive to your property to deal with tenant issues.
- Repairs. Are the repairs to your income property reasonable and necessary? If so, then they are fully deductible in the year in which you incurred them. Examples of deductible property repairs include replacing broken windows, plastering, fixing leaks, fixing gutters or floors, or repainting.
Tax Benefit #3: 1031 Exchange
A 1031 exchange is a great tool for investors to defer taxes on rental properties.
Here’s an example:
Suppose you have a property that you purchased for $100,000. Come 10 years, the property should increase in value provided market conditions remain favorable. Let’s suppose that the property increased by $50,000 in value in the 10 years.
The $50,000 is the capital gain that you need to pay tax on. With a 1031 exchange, however, you’ll be able to defer the tax payment at a later date, and use the money to buy a bigger property.
You can continue to buy larger properties using the 1031 exchange for as long as you want. This opens up the possibility of increasing your cash flow and never actually paying taxes on the investment.
Tax Benefit #4: Opportunity Funds
In the United States, there are over 87,000 opportunity zones. More specifically, there are 126 designated opportunity zones in Colorado. Designated by state governors, these zones are generally for low-income communities. If you invest in these zones, the government will provide you with several tax incentives.
How do opportunity funds work?
With these funds, you’ll be able to make a deferment on any capital gain you make on a capital asset. Capital assets include real estate, mutual funds, bonds, and stocks.
To benefit from opportunity funds, you must invest the capital gains you’ve made on a capital asset into an Opportunity Fund within 180 days after selling the investment.
Every year, millions of landlords in the United States pay more taxes than necessary on the income they make from their properties. The reason behind this is because many fail to take advantage of tax benefits available in Denver Colorado real estate.
This blog aimed to provide you with an overview of some of the tax benefits available to as a real estate investor. If you need more information, please consider hiring the services of a qualified CPA.