How Real Estate Investments Can Reduce Your Taxes

When comparing the relative benefits of investment types, real estate is incredibly unique. Not only is it a tangible asset with high returns, but real estate investment can offer considerable tax advantages as well.

Being able to greatly reduce your tax liability while maintaining returns and diversifying your investment portfolio is one of the best reasons to dive into real estate investing. So how do these tax reductions work?

Real Estate Investment Tax Implications

Let’s start by looking at what happens to the money you invest in real estate and how it is treated for tax purposes when you take it out of your investment through cash flow or a sale.

Let’s say you bought a piece of land ten years ago for $500,000 and sold it this year for $1,000,000.  In this scenario, you would have a $500,000 ‘capital gain’.  For most investors, capital gains tax rates are either 0%, 15% or 20%, depending on the length of the investment. In the worst-case scenario, you would owe $100,000 in taxes on your $500,000 gain and your original $500,000 investment would net you $900,000.

Comparing this to income generated from other investment types (mutual funds, etc.) which are generally taxed at ‘ordinary income’ rates of as high as 37% and it’s easy to see that a real estate investment can shelter significant income for an astute investor.

Real Estate Depreciation and Taxes

But real estate offers even more advantages than just capital gains!  Current IRS code allows for the depreciation of real estate as well as deductions for interest on a property’s mortgage.

Let’s take a look at another example. Let’s say you bought a $1,500,000 apartment building using your $500,000 and a loan with a rate of 5% from a bank for $1,000,000.  The apartment had some tenants that paid $200,000 a year in rents. You had $100,000 in operating expense to maintain the property and pay for utilities, property taxes, insurance, and other expenses so you had a net income of $100,000. Now you pay the bank the 5% interest on the loan, so you paid $50,000 in interest. This leaves you with $50,000 in net cash flow.  Not too bad. . . you made 10% on your $500,000 investment!

Here’s where the tax benefits really come in. Many other cash flow producing investments would require you to pay ‘ordinary income’ taxes on your cash flow. But the tax code allows you to deduct depreciation and interest on real estate investments.

In our example above, the $1,500,000 apartment building could easily have an annual allowable depreciation of $30,000. After adding this to the $50,000 in interest paid on the loan, you get to write off $80,000 worth of losses against the $50,000 in cash flow leaving you with a net tax loss for the year.  For some investors, they can even use these losses to hedge again taxable gains in other investments.

It’s not unusual for real estate investors to be able to enjoy annual cash flow from their investments with little, or no, tax obligation and shelter the gain in their investment through appreciation in the property under capital gains vs. ordinary income. Investments that do not enjoy similar tax benefit may have to produce two to three times the pre-tax returns to deliver a comparable after-tax return.

Real Estate Tax Considerations for Your Next Investment

By coupling the tax benefits of real estate investing along with the ability to have a direct impact on your investment, many investors have created significant wealth through real estate investments. But for some, owning real estate can feel much more complicated and risky than investing in stocks. Managing real estate means you have to deal with tenants and leaking toilets. Borrowing money from a bank can expose you to risks that you may not be comfortable taking.

For many investors, finding a real estate investment partner is a perfect solution. Real estate investment sponsors take care of all the guarantee risks on the debt and manage the day-to-day activities of the property, while you get to enjoy all the same tax advantages.

You are strongly encouraged to speak with your tax and legal advisors when considering a real estate investment, but whether you want to go it alone and create your own real estate portfolio, or partner with other investors and managers, you have a great opportunity to grow your wealth through cash flow and asset appreciation in a highly tax-advantaged manner through real estate investments.

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