More than any other asset class, real estate allows investors to maximize the total potential value of their investments. Real estate has a significant advantage over other investment avenues — stocks, bonds, mutual funds — due to the tax breaks made available to investors.
Learning about the tax advantages of real estate allows you to optimize your property’s benefits to their fullest.
What’s So Special About Real Estate?
Real estate is distinguished by its stability and profitability as an investment, especially in the long term.
While trading on the stock exchange is a popular way to invest, stocks do not have the same advantages as real estate. Many of the features that set real estate apart from other investment avenues also make it a more reliable investment.
Understanding why real estate is such a substantial investment will give you a better idea of what to look for in potential investment properties of your own. One of the most significant advantages of real estate is the tax benefits.
What Are the Special Characteristics of Real Estate?
- Real estate can be improved.
- Scarcity is baked into real estate.
- Investments in real estate are permanent.
- The location makes a huge difference.
Improvability of Real Estate
Real estate allows investors to take an active role in its value.
When buying a company’s share on the stock exchange, investors are effectively powerless over the value of their investment. The company’s performance and indirect market trends are the driving forces behind your shares’ rising and falling prices.
On the stock market, you have zero control over the price of your shares.
Real estate is different. Investors can directly influence the value of their asset by virtue of a property’s improvability. Real property can be altered and upgraded, which affects its total value.
Everything from a new set of kitchen cabinets to a complete renovation of the property will have a marked impact on its value. Investors can, whether slight or extreme, increase the value of their asset through its improbability.
Scarcity of Real Estate
A common truism in investing is that they aren’t making any more land. Trading on the exchange, due to the complexities of stock splits and other market cap alterations, make stock trading an open field; it’s unlikely a given company will run out of stocks.
Real estate, on the other hand, is an inherently finite resource. Zoning, developing, and acquiring a lot of property reduces the total supply of land in the area. The baked-in scarcity of real estate has a profound impact on its value due to the cardinal economic law of supply and demand.
Every parcel of land sold is one lot fewer in the total supply, which drives up the value of that property and the surrounding land. Additionally, developing new properties is a time-consuming and expensive process, which keeps the supply of new property at a slow pace.
Altogether, the implications of real estate scarcity ensure that property investments are highly likely to appreciate over time and retain a stable value over the long term. These two features make property ownership among the safest investment decisions.
The Permanence of Real Estate Investments
The improbability of real estate has a significant impact on the potential value increase of the property. But the permanence of such improvements makes real estate such a stable asset.
Investments in a property virtually infuse capital into the property’s value. Foundational investments made into a property reveal how capital permanently increases the value of the real estate.
Necessary additions and repairs on a property’s connection to the electrical grid and septic system are permanent investments into the asset that raises its value.
Real estate is an investment whose potential doesn’t end once acquired. Further investments into the integrity of the property permanently increase its value in the long run. Investors can rely on real estate because of this incomparable potential for long-term stability.
Real Estate and Location
Perhaps the most distinctive feature that defines real estate is location. Location is a seminal characteristic that defines a property’s value and real estate’s unique features as an asset.
Every share you buy of a given company is worth the same — not so with real estate. A carbon copy of a given property could have a vastly different value in another place due exclusively to the location.
For example, a single-family home in upstate New York will have a significantly different value than the same house in Los Angeles.
The property’s value then is more than just the physical real estate on the lot, but its surrounding area. Location may have more of an impact on the value of an asset than anything else.
Consider the cost of a Los Angeles condo to a luxury home in rural Arkansas; demand for a given location is a dominant factor in real estate value.
Consult our educational resources if you’re interested in learning more about real estate.
Why Does Real Estate Receive Tax Breaks?
Real estate is a cornerstone of a properly functioning society. Whether residential or commercial, societies need well-maintained, essential property to exist.
Real estate investment is a means to incentivize investors toward a more robust real estate market. With more capital flowing into the market, property is better equipped to function as it must for the stability of society.
Investments in real estate are an added assurance that property continues to carry out its essential role in the United States.
Investing in real estate can be expensive. Property ownership has high financial thresholds compared to conventional investing strategies. Furthermore, property ownership is a long-term investment, with operating expenses that quickly add over time.
To offset the high costs of real estate investing, the government offers committed investors tax breaks to facilitate a steady influx of capital into the real estate market.
By making it easier for investors to participate in the market, the market is sustained with the capital that creates a more effective market.
What Tax Advantages Can You Use on Real Estate?
- Depreciation
- Utilize write-offs
- Long-term gains over short-term gains
- 1031 exchanges
Depreciation
To offset the waning value of a property over time, property owners can factor in an asset’s depreciation as a tax write-off.
Naturally, a property becomes less valuable over time: the property degrades from the corrosive effects of things like weather, termites, and time.
Writing off the depreciating value of the property incentivizes property owners to make ample repairs on their property to keep it in good shape.
The expectation behind depreciation write-offs is that the money accounts for “phantom expenses,” which includes the assumed wear and tear that the property owner will likely pay for in the future.
How Does Depreciation Work?
To calculate a property’s depreciation write-offs, the property owner must first establish the property’s actual structure as differentiated from the land. When buying a property, you’re paying for the land and the physical structures on the land.
As depreciation only concerns the diminishing value of the structures and not the land, you must clearly grasp the value of the property’s structures as a separate entity: its basis.
Once you establish the value of the property basis, you divide that number by the years of its useful life: 27.5 for residential properties and 39 years for commercial properties.
If the total value of your residential property structure were $60,000, the depreciation rate for your property would be around $2,181.81.
The depreciation rate is deducted from the income earned by the property. In the case of a rental property that makes $10,000 a year, $2,181.81 could be written off from your taxes, thanks to depreciation.
Utilize Tax Write-Offs
Property ownership comes with several operating expenses. Mostly, you can write off these operating expenses when you file your taxes. Operating expenses that you can deduct from your taxes include:
Property Taxes
Property taxes vary by state. Thankfully, you can write off the taxes you pay on your property as operating expenses when it comes time to file.
Mortgage Interest
The interest generated by a property mortgage can be an ongoing expense. Your mortgage interest can be written off at the end of the year to lessen the effects of these drains on cash flow.
Property Insurance Payments
Insuring your property is a must: it ensures that you and your tenant are protected from unforeseen events that can cause physical or financial damage. Property insurance payments can be written off to encourage owners to insure their property.
Management Expenses
Running a property is hard work. Many property owners hire management companies or employees to handle their property. As these are business expenses, they can be deducted from your taxes when you file.
Maintenance and Repairs
Things fall apart throughout the property’s lifespan. Fixing broken toilets, holes in the wall, and other wear and tear on the property can be written off.
More involved real estate investment operations can write off additional expenses that serve the business’ proper function.
These include:
- Advertising costs
- Travel fees
- Office space
- Legal costs
- Equipment costs
Long-term Gains vs. Short-term Gains
Capital gains taxes can affect your total take-home return; they are determined when you sell an asset for a profit.
Understanding the difference between long-term and short-term gains and how they’re taxed can help you formulate a real estate investment strategy that enables you to take home as much of your return as possible.
Short-Term Gains
Short-term gains are profits that are earned by an asset within a year. The IRS taxes short-term gains as income. That means that if you sell a property within a year, the money you’ve earned on the property will influence what income tax bracket you fall under at the end of the year.
Real estate sells for a significant amount. Even a modest sale can put you into a new tax bracket if they qualify as short-term gains.
Long-term Gains
Long-term gains are taxed much lower than short-term gains; anything sold after a year qualifies for long-term gains. The lower tax rate for long-term gains encourages investors to hold onto assets.
In doing so, you may have the time to make ample repairs and maintenance on your property.
Waiting the entire year to sell your property can make all the difference in what you can take home in full. When you’re holding for the long-term with a rental property, your qualification for a long-term gains tax rate is assured.
1031 Exchanges
A 1031 exchange allow real estate investors to utilize substantial tax advantages. A 1031 exchange is effectively a 1-to-1 swap of one investment property to another.
Real estate is disadvantaged by its high illiquidity; it takes a long time to turn a property into liquid capital. 1031 exchanges offset the high illiquidity of real estate by making it easier to liquidate a property from one to another.
How Do 1031 Exchanges Work?
The IRS has strict guidelines on how to qualify for a 1031 exchange. This financial move is meant to ease the exchange of assets for real estate investors.
1031 exchanges do not work for homeowners looking for a new home; to qualify, investors must demonstrably show they intend to use the exchange on an income-earning property.
Exchanges must be a “like-kind exchange” by property class: a residential property for a residential property. If an exchange qualifies as like-kind, investors receive the liquid capital of their property’s value to use on the property they intend to acquire. With a few exceptions, the exchange must be completed within 180 days.
Crucially, 1031 exchanges avoid capital gains taxes. They allow investors to seamlessly swap one like-kind property for another, facilitating faster, more effective trading in the real estate market with a complete return.
Utilizing Tax Advantages
Real estate has several tax advantages that will help you maximize your return. Utilizing these tax advantages in practice means setting aside the time to gather the proper documentation you need to file.
Property ownership is a time-consuming enterprise. Utilizing the tax advantages of real estate can take even more of your time. It may be best to consult a third party to help you file for your tax advantages.
To get the most out of tax-advantaged real estate investing with little burden on your time, consider investing with a firm.
Invest With The Best
Christina has thrived in the Los Angeles real estate market for over four decades. Our success is due in large part to the expertise of our team. We have a complete grasp on tax-advantaged real estate that helps us help you.
Make the most of tax-advantaged real estate investing with a firm that understands the tax code inside and out.
Get started today and save on your taxes tomorrow.
Sources:
Topic No. 703 Basis of Assets | IRS