How real estate investors pay almost no taxes

It's a common misconception that real estate investors pay "almost no taxes." While they benefit from numerous tax advantages that can significantly reduce their tax liability, it's unlikely for them to pay absolutely zero in taxes consistently over the long term. However, through strategic planning and utilizing various legal provisions in the tax code, they can minimize their tax burden considerably.

Here are the key strategies and tax benefits that real estate investors use:

1. Depreciation:

• This allows investors to deduct a portion of the property's value each year over its useful life (27.5 years for residential, 39 years for commercial), even though the property may be appreciating in value.

• It's a non-cash expense that reduces taxable income.

• Cost Segregation: This advanced strategy allows investors to identify and reclassify certain components of a property (like flooring, fixtures) with shorter useful lives, enabling accelerated depreciation deductions in the early years of ownership. This is a very hot topic that will get its own post shortly.

2. Deducting Operating Expenses:

• Investors can deduct ordinary and necessary expenses related to managing and maintaining their rental properties. These include:

  • Mortgage interest

  • Property taxes

  • Insurance

  • Repairs and maintenance

  • Property management fees

  • Advertising costs

  • Utilities (if paid by the landlord)

  • Legal and accounting fees

  • Travel expenses related to managing properties

3. 1031 Exchanges (Like-Kind Exchanges):

• This powerful tool allows investors to defer capital gains taxes when selling an investment property and reinvesting the proceeds into a "like-kind" property within a specific timeframe.

• It essentially allows investors to roll their profits into new investments without triggering a taxable event, potentially deferring capital gains taxes indefinitely.

4. Qualified Business Income (QBI) Deduction:

• Under Section 199A, eligible real estate investors operating as pass-through entities (sole proprietorships, partnerships, LLCs, S-corps) may be able to deduct up to 20% of their qualified business income (net rental income).

5. Capital Gains Tax Rates:

• When an investment property is sold for a profit, the gains are taxed at capital gains rates, which are generally lower than ordinary income tax rates, especially for assets held for more than a year (long-term capital gains).

• Current long-term capital gains rates are 0%, 15%, or 20% depending on the investor's taxable income.

6. Avoiding FICA Taxes:

• Rental income is generally not subject to self-employment taxes (Social Security and Medicare taxes), unlike income earned from wages or active business activities.

7. Opportunity Zones:

• Investing in designated low-income communities (Opportunity Zones) can provide significant tax benefits, including the potential deferral and even elimination of capital gains taxes on the appreciation of the investment over the long term. Here is some unique information about opportunity zones.

8. Borrowing Against Equity:

• Instead of selling a property and triggering capital gains taxes, investors can often borrow against the equity in their properties through refinancing. The borrowed funds are not considered taxable income.

9. Tax-Advantaged Retirement Accounts:

• Self-directed IRAs or other retirement accounts can be used to invest in real estate, potentially offering tax deferral or tax-free growth depending on the account type.

10. Utilizing Losses:

• In some cases, real estate investors may be able to offset passive losses from rental properties against other passive income. Real estate professionals who meet specific criteria may even be able to offset these losses against ordinary income.

Example Scenario:

Imagine a real estate investor owns a rental property. They collect $20,000 in rental income and have $15,000 in deductible expenses (including depreciation). This reduces their taxable income from the property to $5,000. If they are in a higher tax bracket, this depreciation deduction can save them a significant amount in taxes compared to other types of income. If they later sell the property for a substantial gain, they might utilize a 1031 exchange to defer paying capital gains taxes by reinvesting the proceeds into another property.

Important Considerations:

• Tax laws are complex and subject to change. It's crucial for real estate investors to stay informed and consult with experienced tax professionals to ensure they are utilizing all available legal strategies and complying with current regulations.

• "Almost no taxes" is an exaggeration. While the tax benefits are substantial, investors will likely pay some form of tax over time, whether it's capital gains when they eventually sell without a 1031 exchange, or taxes on the income after deductions.

• Aggressive tax avoidance schemes can lead to IRS scrutiny and penalties. Investors should focus on legitimate tax planning strategies within the bounds of the law.

In conclusion, real estate investors can significantly reduce their tax burden through a combination of deductions, strategic planning, and utilizing specific provisions in the tax code. While complete tax avoidance is unlikely, these benefits make real estate a tax-advantaged investment compared to many others.