One of the most frequent questions I get asked is this: How does one legally reduce their tax liability through real estate investing? There are a number of different benefits that are available to you as an investor, and generally speaking, the tax code works in our favor.

First, it’s important to understand why real estate investors enjoy tax benefits in the first place. The United States’ tax code is written to incentivize private industry, not to raise revenue for the government. For example, the government encourages small business owners to hire employees, purchase equipment, and reinvest into their business by way of tax benefits.

The real estate business is supported in a similar way. Rather than the government taking on the task of housing 330 million people, they rely on private industry to innovate and create opportunities through owning, renting and maintaining real estate assets.

To get the most bang out of your investment bucks, a solid starting point is a concept I like to call “The 3 D’s of Real Estate”: deductions, depreciation and deferrals. Let’s dive in!

Disclaimer: Before I go any further, remember that tax season looks different for everyone, and how these concepts are applied will ultimately depend on your unique situation. Always consult a CPA or tax attorney before making any major investment decisions.

Deductions

The number one tax benefit available to real estate investors is through deductions on the front end. Common deductions include (but of course are not limited to) the interest on your mortgage and business-related costs, like advertising spends and hiring property management.

Ideally, you’ll use these additional dollars to reinvest in your properties, rinse, and repeat.

Depreciation

Almost everything has a shelf life, or an amount of time it can be safely used. In real estate, we use a similar idea called “useful life,” or the estimated duration it will take for something to wear out. From roofs and HVAC systems to carpets and kitchen appliances, everything depreciates in value over time.

Depreciation is a tax break that allows you to set aside funds for inevitable repairs. Currently, the government sets this recovery period at 27.5 years for residential properties. So, if you paid $100,000 for an income-generating rental property, you’d divide that number by 27.5 to get to the amount you could potentially write off as depreciation:

100,000 / 27.5 = $3636

Therefore, depreciation alone lowers your taxable income by roughly $3,600. That’s a pretty nice gift from Uncle Sam.

(Note that depreciation can only be applied to the property’s structure, not the land it’s on)

Bonus Depreciation & Cost Segregation

Hold on—don’t carpets wear out quicker than a roof? (Well, let’s hope so.) Or what if you don’t plan to hold the asset for three decades? Let’s talk about the concepts of bonus depreciation and cost segregation.

Rather than depreciating your property at the same rate over 27.5, bonus depreciation allows you to accelerate that depreciation in your first year of ownership, deducting some of the projected costs upfront. In fact, The Tax Cuts and Jobs Act of 2017 doubled the amount of bonus depreciation you can claim for qualified properties.

Cost segregation, which must be conducted by a certified professional, analyzes various components of a property and segments them into different depreciation schedules, typically 5, 7 and 15 years.

As always, it’s best to check with your CPA before claiming these specialized deductions come tax time.

Deferrals

Deductions and depreciation are major perks when you own the property, but tax benefits don’t stop there. Let’s say you sell that $100,000 property for $300,000 after five years. Through something called a 1031 exchange, you can defer any tax obligations on your $200,000 capital gains into a similar (also known as “like”) property. There’s no limit on how many 1031 exchanges you can take, so theoretically, you could continue this cycle indefinitely.

Opportunity Zones

But wait, there’s more. if you roll your capital gains into a property that’s within an “opportunity zone” and hold it for ten years, you wouldn’t have to pay tax on that gain at all. Ever. Opportunity zones are distressed areas where the government is looking to spur economic growth and job creation.

Last, But Not Least…

Real estate is an important driver of our economy, and as such, it’s an industry that the IRS tends to reward.  If you’re curious about investing in real estate but worry about the tax implications, we hope this information gives you a clear picture of what to expect and how to make the tax code go to work for you. If you want to hear more from us, check out our weekly podcast, where we sit down with successful investors to uncover their secrets in the real estate investing space.

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