Watching someone on TikTok tell you about all the amazing benefits of owning rental properties should NOT be the reason you do. They can be a wonderful long-term investment and at the same time can suck you dry if you’re not careful.
One of the many perks of owning rental properties is the array of tax benefits available to real estate investors.
Let’s explore the tax advantages of own rental properties, including deductions, credits, and exemptions. To illustrate these benefits, we’ll delve into a real-life example of how a rental property owner can leverage tax advantages to maximize their financial gains.
- Mortgage Interest Deduction:
One of the most significant tax benefits of owning a rental property is the ability to deduct mortgage interest payment. This deduction applies to the interest paid on the mortgage used to acquire or improve the property. For example, if you have a $300,000 mortgage on your rental property with an annual interest rate of 4%, you could deduct $12,000 in interest payments from your taxable income each year. It’s important to note that this deduction is NOT limited to just one rental property; if you own multiple rental properties, you can deduct the mortgage interest on each of them!
- Property Depreciation:
The IRS allows property owners to depreciate the value of their rental property over time as it theoretically “wears-out.” This depreciation expense can be deducted from your rental income each year.
For instance, suppose you have a rental property worth $250,000, excluding the land’s value. The IRS typically allows you to depreciate residential rental property over 27.5 years. This means you could deduct approximately $9,090 ($250,000/27.5) in depreciation expenses annually from your rental income.
- Property Expenses Deductions:
Owners of rental properties can deduct a wide range of expenses associated with managing and maintain their properties. Some common deductible expenses include:
- Property management fees
- Property insurance premiums
- Repairs and maintenance costs
- Utilities paid by the landlord
- Property taxes
- HOA fees
- Advertising and marketing expenses to attract tenants
- Passive Loss Deduction:
If you actively manage rental properties, you may be able to deduct up to $25,000 in passive real estate losses against your other income, such as salary or business income, if your modified adjusted gross income (MAGI) falls below a certain threshold. Be careful with this one. While it provides many obvious benefits, it’s very nuanced and strategies with this should be consulted with your CPA or tax pro
- 1031 Exchange:
The 1031 exchange is a powerful tax strategy that allows real estate investors to defer capital gains taxes when selling one rental property and reinvesting the proceeds in another similar property. For example, let’s say you sell a rental for a profit of $100,000. Instead of paying capital gains taxes on that profit, you reinvest the entire $100,000 in another rental property. By doing so, you can defer the tax liability until you eventually sell the replacement property without triggering a taxable event.
Let’s look at an example!
John owns a rental property, a two-bedroom condo located in a nice neighborhood near a university. He purchased the condo for $200,000 several years ago, financing it with a mortgage. Here’s how John leverages the tax benefits of rental properties:
- Mortgage interest deduction: johns annual mortgage interest payments amount to $8,000. By deducting this interest from his rental income, he reduces his taxable income by $8,000.
- Property Depreciation: The condo’s value, excluding the land, is $150,000. John can depreciate this property of 27.5 years, allowing him to deduct approximately $5,455 ($150,000/27.5) in depreciation expenses from his rental income each year
- Property expenses deduction: John incurs various expenses to maintain the condo, including property management fees, property insurance, property taxes, and repair costs. In total, these expenses amount to $6,000 per year. He can deduct this amount from his rental income.
- 1031 Exchange: After several years, John decides to sell his condo and reinvest the proceeds to a larger rental property, a duplex, worth $300,000. By utilizing the 1031 exchange, he defers capital gains taxes on the profit from the condo sale, allowing him to reinvest the entire proceeds in the new property.
It’s important to note that tax laws and regulations change, so it’s crucial to consult with a tax professional or financial advisor who specializes in real estate investments to ensure you’re making the most of these benefits while staying compliant with the current tax laws.
While these benefits are still available for rental property owners, don’t let the tax tail wag the dog! Buying a rental property for the tax benefits alone can be a sure fire while for you to lose money and most importantly, time and stress. Make sure to do your due diligence before buying a property and bounce ideas of friends or family who have owned properties in the past. Interest rates are no longer 3%; making owning rental real estate and generating positive cash flow that much more difficult.
