You’ll appreciate your real estate investments most at tax time
Fortunately, the government is smart enough to realize that private property owners make better landlords than it does. When you own real estate and make it available to renters, you are performing a very valuable service for your community, and the government rewards you with some impressive tax benefits.
Even with recent tax law changes, real estate is still one of the best, if not the best, tax-sheltered investments you can own. But it’s not the gravy train it was before the 1986 tax law revisions. In its heyday, people used real estate to shelter incomes in excess of a million dollars a year and paid no federal income tax.
Unfortunately, those glory days are over, but the remaining benefits make real estate one of the most lucrative assets you can own. Before I go any further, let me make it clear that I’m not a tax adviser, just an investor willing to discuss the benefits I have experienced firsthand. For guidance on your personal situation, you would be wise to consult a professional tax adviser.
Look at your paycheck stub and you will notice a deduction for Federal Insurance Contributions Act. Not only do you pay this tax, but your employer must match, too. Earned income is subjected to the FICA tax, and there’s no way around it until your income surpasses a certain amount. Both the tax rate and the amount subject to the tax have been steadily rising.
On the other hand, rents you collect from real estate, no matter how large they grow, are considered passive income and are exempt from both the employee and employer share of FICA taxes. Just this tax break alone is a tremendous reason to own real estate.
You can also deduct all expenses associated with investment real estate to reduce the amount that is taxable. You can deduct things like interest expense, management fees, taxes, insurance, repairs, homeowner’s dues, utilities, legal and accounting fees, and any other expenses incurred from owning and renting property. You even get to deduct a portion of the purchase price each year in the form of depreciation.
If, after taking all of the allowed deductions, your income is zero or you show a loss on paper, you will pay no ordinary income tax and, under limited circumstances, may be able to apply some or all of the loss to offset taxes on your salary. Here’s where a professional tax adviser may help.
The interest deduction plays an important role, especially when you’re just getting started and cash flows are tight. Most investors finance as much as possible in the beginning; interest is most likely their largest expense. Over time as the mortgages pay down and rents increase, the interest deductions will decline but the cash flow will increase. When the mortgage is paid off, although there may be some tax to pay, investors will get to keep a substantial part of the income because they won’t be paying interest.
There are so many additional tax benefits to real estate it’s hard to do justice to all of them in this limited space. There are ways to sell properties and defer taxes on the profits if you if you reinvest them in additional properties. Even if you don’t reinvest them, if you have owned the properties for at least a year, the profits are taxed at a very favorable capital gains rate, which can be less than half the rate for ordinary income. Under the current Internal Revenue Code, you can avoid paying taxes altogether on profits up to $250,000 from the sale of your personal residence and can do it again every two years. (Double that if you’re married and filing jointly.)
courtesy of Mike Summey
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