Among the many advantages of investing in real estate are the unique tax benefits available with this asset class. Whether you are interested in becoming an active real estate investor by purchasing a piece of commercial property directly and operating it yourself, or becoming a passive investor by purchasing an equity stake in a private real estate fund, there are several tax benefits available to you that investors in other asset classes (such as stocks and mutual funds) do not receive. This post will discuss several of these advantages.
Real estate revenue is taxed at a lower effective rate than ordinary income
If you own and operate a piece of real estate (say, a small apartment building) federal law allows you to depreciate the cost of the property over 27.5 years, even if its value is actually increasing from year to year.
This means that each year you could potentially have many thousands of dollars of on-paper “losses” on the building, which you can use to offset any rental income or other revenue you’ve earned on the property.
Thanks to this significant deduction, taken together with the many other tax-deductible expenses you can apply against your property’s income each year, your real estate revenues will often be taxed at an effective rate that is far lower than ordinary personal or corporate income.
You can carry your real estate rental losses forward
Another tax benefit of real estate investing is that, although there are limitations on the amount of passive-income losses the tax code allows you to take on your investment property in any given year, you can carry losses exceeding this amount forward.
This means that when your real estate investment does begin generating significant enough profits that your depreciation and other deductions don’t fully cover them, you can bring forward a previous year’s losses to write down your taxable income. Often this will bring your investment property’s tax bill down to almost nothing even in a year when you’ve enjoyed a substantial profit on the property.
You can defer your taxes on real estate gains with a 1031 exchange
Here’s another way that the federal government offers unique tax benefits to encourage property ownership.
If you were to sell an investment property and simply pocket the cash, you would face a capital-gains tax bill for that year on the amount you earned in the sale after factoring in expenses. But with a 1031 exchange, the government allows you to postpone paying any taxes on the sale of an investment property.
Called a “like-kind exchange,” by the IRS, the process works like this: When you sell an investment property, you will purchase a similar type of property within a specified time period after the sale. (Typically, the IRS requires that you identify the specific property you intend to buy and deliver a written record of your intention to an involved party, usually the seller. Then you will need to complete the purchase within 180 days after the sale of your property.)
If you meet these requirements (and a few others), then you can postpone paying any federal taxes on the gains from your investment property’s sale until you sell this new property – unless, of course, you complete another 1031 exchange when you sell this one, which is also perfectly legal. In other words, although the IRS points out that a 1031 exchange can make your property sale “tax deferred but not tax-free,” the reality is that you can use this strategy to put off paying capital-gains taxes on your investment real estate for as long as you choose.
Real estate capital gains are far lower than ordinary income
Even if you sell your investment property and do not complete a 1031 exchange to defer your tax bill, you will still likely pay less for those gains than you would on ordinary income.
Real estate sales are taxable as capital gains, which means if you’ve held an investment property for more than one year, you will be taxed at the long-term capital-gains rate. For 2018, assuming you are a high-income individual, that will be 15% or at most 20%, far lower than the 37% you might be paying for your ordinary income.
(If you sell your investment property within a year of purchasing it, however, you will be taxed at the short-term capital-gains rate, which is the same as your ordinary income rate. This is one of many reasons to hold real estate investments for the longer term.)
Perhaps the biggest tax benefit of all: investing in a private real estate fund
To this point, we have been discussing only the more active type of real estate investing (although the IRS still considers it a “passive investment”), in which an investor purchases and manages a piece of property directly. The tax benefits of this type of real estate investing are clearly significant.
But when you instead take the more passive approach of investing in commercial real estate through a private fund, your equity stake in the many individual investments that fund makes will benefit from the tax advantages we’ve already discussed – while also benefiting from another unique tax advantage.
The federal tax code typically treats private real estate funds as pass-through entities, meaning that all of the income and losses are applied directly to the owners. This means that as an investor in the right private real estate fund, you will not face the double-taxation often paid by the shareholders of a corporation, which is how the tax code treats REITs. It also means you will be taxed only on your share of the fund’s reported income or losses for the given tax year, and typically at the lower long-term capital gains rate.
If you’d like help identifying the right fund to help you take advantage of the unique tax benefits of real estate investing, let us introduce you to the leading fund for Kansas City multifamily real estate.
This does not constitute an offer to purchase securities, and that any purchase may be made only through delivery and receipt of a confidential private placement memorandum from the issuer, pursuant to which any potential investor must complete and provide an investor questionnaire, subscription agreement and other things required by the issuer, and are subject to the issuer’s verification of accredited investor status and issuer’s acceptance of the subscription