Real estate can be one of the best investments, often gaining value after enough time passes. In addition to the extra money it can bring in, though, the tax benefits of real estate investing, such as credits, cannot be underestimated.
These credits can vary from one year to the next, but there are things investors can do every year to reduce their tax burden, including taking advantage of real estate investment tax deductions. The key is to keep documentation throughout the year and be prepared to maximize every credit available at tax time.
Tax Credits for Real Estate Investors
Business owners of all types are required to pay taxes on the income they earn. This includes self-employed individuals and investors. If you aren’t on salary with an employer, having taxes taken out of each paycheck, you’ll see a big tax bill in mid-April, plus penalties, which is why you’re required to pay quarterly if you work for yourself. If you’re a real estate investor, you’ll owe taxes on any money you make from rent, as well as capital gains if you sell the property.
So, how do tax credits work for real estate investors? As with many self-employment ventures, real estate investment allows for a certain amount of tax relief to offset those taxes. Credits encourage investors to continue to purchase properties, thereby stimulating the economy.
On the other hand, real estate investment tax deductions give an investor credit for the money he spends in the course of running his business. Both serve to reduce the amount of taxes an investor owes each tax year.
Read More: Tax Credits: What Are They & How Do You Qualify?
Taxes on Real Estate Property
When you own real estate property, you won’t pay income tax on that property until you sell it, and even then, you’ll only pay it if you have a capital gain. In other words, if you sell the property for more than you originally paid for it, you’ll need to report that income and pay according to the tax laws at that time.
However, the IRS encourages real estate investment by differentiating between short- and long-term gains. In other words, if you’re a home flipper who buys a house, puts a little money into it to fix it up and flips it for a huge profit months later, you’ll be taxed on the money you made as ordinary income.
If you hold the property for one year or longer and the IRS doesn’t classify you as a “dealer,” you’ll owe only the long-term capital gains tax rate on that property. Under the current tax laws, this rate is 0, 15 or 20 percent, depending on your total taxable income for the year.
A married couple filing jointly and qualifying widows and widowers will pay no tax on gains from their home sale as long as their combined taxable income falls below $80,800 that year. The rate goes up to 15 percent once their income exceeds that, going to 20 percent if they earn $501,600 or more that year. However, the singles’ limit is $445,850, while heads of households have a threshold of $473,750.
Investor vs. Dealer
If you’re investing in properties on the regular, you may achieve “dealer status” by the IRS, which means you’ll be taxed at a higher rate than if you’re seen as an investor. The guidelines for this classification can be a bit murky, but in general, the IRS looks at an investor’s behavior to determine whether she qualifies as a dealer or investor.
If you own a second home as a vacation property and eventually make a profit on the sale, you’ll safely maintain investor status. However, if you’re making a living as a property investor, you may find it difficult to escape the classification.
Dealers are generally those who purchase properties and later sell them on an ongoing basis. Advertising your services and marketing your properties may also push you into dealer territory.
If you’re buying properties, dividing them up, arranging for development and similar types of activities, you can earn dealer status because you’re behaving in a developer role. This doesn’t mean that you can’t buy a piece of property and divide it up to remain an investor. You just may find this earns closer scrutiny than if you own a couple of vacation homes for later resale.
Taxes on Rental Property
For real estate investors, rental property can bring regular cash flow. A good property in the right location can attract long- or short-term renters who pay hundreds or thousands each month. But every dime of those rental payments must be reported on your taxes, listed as rental income on Form 1040, Schedule E, Part I. You will be asked to detail the type of property, the number of fair rental days and the number of days set aside for personal use.
There are other payments, as a landlord that you’ll be required to report on Schedule E. Those include advanced rental payments and security deposits in the year that you receive them.
However, if you plan to return a security deposit at a later date, there’s no need to report them on your tax return. If you keep any of that deposit, though, you’ll be required to report it as income in the year you decide to keep it.
If a tenant pays any of your expenses, you’ll also need to report those payments as income. If a tenant offers to render services and have those services deducted from his rent, you’ll need to determine the fair market value of those services and report that amount as income.
Nonrefundable vs. Refundable Credits
The IRS offers two types of credits: nonrefundable and refundable. A nonrefundable credit simply reduces the amount a taxpayer owes. So, if you file your taxes in mid-April and find you owe $5,000, $1,000 in tax credits will mean you’ll write a check for $4,000.
On the other hand, if you owe $1,000 and have $2,000 in tax credits, your balance due will reduce down to $0 and the rest of the credit will disappear. You won’t receive a “refund” of $1,000 because the credit was nonrefundable, and you can’t carry that extra $1,000 over to next year.
A refundable tax credit is more desirable because it hands you money back whether you owe taxes or not. So that $1,000 tax credit will be issued as a check to you if you find you owe nothing when you file. If you owe more than $1,000, the credit will be applied, and you’ll owe whatever remains. If you owe only $500, you’ll be issued a check for $500, which is the original $1,000 credit minus the $500 you owed.
Community Renovation-Based Tax Credits
All the gentrification seen across the country is good for the economy. To encourage this, the government offers tax credits to investors who put their money into communities considered low-income.
The New Market Tax Credit Program offers a tax credit to investors who buy properties in certain areas. The credit is a whopping 39 percent of the amount they put into the property, distributed over a period of seven years. However, there is a cap on the number of investors who can qualify for the credit, which makes it highly competitive.
Investors may have better luck offsetting the cost of real estate taxes by taking advantage of the Low-Income Housing Tax Credit.
The credits are issued to states to distribute to developers in order to encourage low-income housing developments in various areas. Developers then offer those credits to investors in order to raise the money they need to initiate housing projects.
Other Tax Credits
Investors who choose properties related to gentrification may get some relief from the Rehabilitation Tax Credit. This one is designed to encourage developers to renovate, restore and reconstruct older buildings. It applies to structures initially put into service before 1936, offering a 10 percent credit. If a building is classified as historic in the tax year in question, it may qualify for a 20 percent tax credit.
The Tax Cuts and Jobs Act affects the Rehabilitation Tax Credit, requiring developers to take the discount over five years rather than all at once in the year they put the building into service. It also eliminates the 10 percent credit for pre-1936 buildings, which means this credit will only apply if your building has been certified as historic.
If you perform modifications on your property that qualify as energy-efficient, you may be able to claim the Residential Energy Tax Credit. You’ll use Form 5695 for this and detail the amount you spent on each type of improvement, including solar electric, solar water heating, small wind energy or geothermal heat pumps.
If you install energy-efficient appliances in any of your properties, you should also check on any credits that might apply in the current tax year.
Property Tax Deductions
If you own more than one home, you can deduct property taxes each year under the state and local taxes deduction provision.
However, the Tax Cuts and Jobs Act puts a cap on the amount you can claim, maxing you out at $10,000 when filing jointly, for the amount you can claim for income, sales and property. This can be a significant change if you rely on those discounts to offset your tax burden each year.
Under the new laws, though, you may find that any real estate tax credits benefit you more as a landlord rather than a property owner. The problem is that under the new law, you can only claim up to $750,000 in mortgage interest, which may be a problem if you own more than one home. Under some circumstances, though, that limit increases to $1 million.
If you rent that same property, though, you’d be able to deduct some of the expenses related to maintaining it, giving you a better tax break than if you’d simply left the property empty for personal use a couple of times each year.
Read More: The Tax Liability of Selling an Investment Property
Depreciation Tax Deductions
Tax credits aren’t the only way to reduce the taxes you owe each year. If your investment ventures are your business, you can claim expenses related to running that business, including your office space, your mileage, the amount you pay to employees or independent contractors and other expenses directly connected to building and growing your business.
You can also claim the cost of insurance you carry on your properties and any expenses related to keeping it functional for rental purposes. If you pay fees to list your properties on rental sites or in local publications, you can claim those costs as well.
Perhaps one of the most popular deductions for rental property owners, though, is depreciation on your properties. You can claim depreciation on your property for up to 27.5 years of its life, but you’ll need to know how to calculate it.
As with many other assets, over time your property will lose value, so you’ll simply divide the value of your property by 27.5 years and claim the answer to that on your taxes each year.
You will then pay taxes on that yearly amount rather than the entire value of your property every single year. This can help you save significant money on taxes for any properties you rent.
- Fit Small Business: Top 20 Benefits of Investing in Real Estate from the Pros
- IRS.Gov: Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses) 5
- IRS.Gov: Estimated Taxes
- IRS.Gov: Topic No. 409 Capital Gains and Losses
- Bradford Tax Institute: Defining “Real Estate Investor” and “Real Estate Dealer”
- CDFIFund.Gov: New Markets Tax Credit Program
- HealthAffairs.Org: Using The Low-Income Housing Tax Credit To Fill The Rental Housing Gap
- IRS.Gov: Rehabilitation Tax Credit - Real Estate Tax Tips
- IRS.Gov: Topic No. 503 Deductible Taxes
- IRS.Gov: Publication 936 (2021), Home Mortgage Interest Deduction
- IRS.Gov: Publication 946 (2020), How To Depreciate Property
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.