How Real Estate Investments Build Wealth and Reduce Your Tax Liability
Real estate is a popular investment because it can build wealth through multiple channels, including property appreciation, rental income, and equity accumulation. A significant part of this wealth-building potential comes from the ability to leverage a variety of tax benefits.
Here's a breakdown of how real estate investments can build wealth and provide tax advantages:
Rental Income: Owning a rental property provides a consistent cash flow. The money you collect from tenants can be used to cover expenses, pay down the mortgage, and provide a passive income stream.
Appreciation: Historically, real estate values tend to increase over the long term. This appreciation builds equity in the property, increasing your net worth.
Equity Buildup: As tenants' rent payments cover your mortgage, the principal of the loan is paid down. This process, known as equity buildup, is a form of forced savings that increases your ownership stake in the property.
Leverage: Real estate allows you to control a valuable asset with a relatively small amount of money down. Using borrowed money (a mortgage) to finance the purchase can amplify your returns as the property value appreciates. For example, taking out a mortgage on a property is essentially using leverage to purchase assets.
Example: The investor uses the $100,000 for 20% down payments to buy a investment property. This requires borrowing $400,000.
After one year, the property increased in value by 5%.
Total property value: $525,000 ($500,000 * 1.05)
Total debt: $395,000 (rough estimate of debt paydown using your tenants money).
Investor's equity: $130,000 ($525,000 - $395,000)
Gain: $30,000 ($130,000 - $100,000)
Cash-on-cash return: 25% ($30,000 / $100,000), which is 30% ROI in one year.
*Note - 5% appreciation is not guaranteed per year. I would forecast 2%-6% to account for down years (2024 and 2025 as examples).
Saving on Taxes with Real Estate
The U.S. tax code provides numerous benefits for real estate investors, which can significantly reduce your tax burden and enhance the value of your investment.
Key Deductions and Tax Strategies
Depreciation: This is one of the most powerful tax benefits. The IRS allows you to deduct a portion of the property's value (excluding the land) each year to account for "wear and tear." For residential properties, the depreciation period is 27.5 years, while for commercial properties, it's 39 years. This is a "non-cash" deduction, meaning you don't have to spend any money to claim it. It can create a "paper loss" on your taxes, even if the property is cash-flow positive, which can be used to offset your rental income and potentially other income.
Accelerated Depreciation (Cost Segregation): A cost segregation study is a more advanced strategy that identifies and reclassifies certain property components (like carpeting, appliances, and fixtures) with shorter useful lives, allowing you to depreciate them more quickly. This front-loads your deductions and provides greater tax savings in the early years of ownership. If you are interested in cost segregation studies, please reach out to me. There is also another strategy called the “Poor Mans” 1031. This is essentially when you sell a property, buy a new property, and perform a cost segregation study on the newly purchased property in the same year, minimizing your gains recognized on the initially property. *More information on this in the future.
Deductible Expenses: As a real estate investor, you can deduct a wide range of expenses associated with owning and managing your property. These can include:
Mortgage interest
Property taxes
Property insurance
Property management fees
Repairs and maintenance costs
Advertising and marketing expenses
Legal and accounting fees
Travel expenses related to the property
1031 Exchange (Like-Kind Exchange): This provision allows you to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into another "like-kind" property of equal or greater value. This allows you to grow your portfolio without an immediate tax liability. You can repeat this process with subsequent properties, potentially deferring taxes indefinitely until you sell a property and don't reinvest the proceeds.
Long-Term Capital Gains: If you sell a property you've held for more than a year, the profit is taxed at a lower, long-term capital gains rate. This is a significant advantage over short-term gains (ordinary), which are taxed at a higher ordinary income rate.
Qualified Business Income (QBI) Deduction: The Tax Cuts and Jobs Act of 2017 introduced a pass-through deduction that allows many real estate investors to deduct up to 20% of their qualified business income (which includes rental income).
Avoidance of FICA Taxes: Unlike earned income from a job, rental income is generally not subject to FICA taxes (Social Security and Medicare), which can be a significant savings.
Opportunity Zones: The Opportunity Zone program encourages investment in economically distressed communities. By reinvesting capital gains into a Qualified Opportunity Fund, you can defer taxes on those gains and potentially eliminate future capital gains tax on the new investment if you hold it for at least 10 years.
Cash out Refinance: Essentially a way to access the equity on your property without selling it. The cash-out refinance is a type of mortgage refinancing that allows you to convert a portion of your home's equity into a lump sum of cash. It involves replacing your current mortgage with a new, larger one. The new loan is for the amount you still owe on your old mortgage plus the additional amount you want to "cash out. Since debt is a non-taxable event, you can access these funds without being taxed. Note: You have to ensure you have a sufficient amount of equity and a good debt to equity ratio in the property.
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