7 Heavy-Hitting Items Every Passive Real Estate Investor Should Know About Taxes

By Amanda Cruise

Do you get excited to talk about taxes? Is it the first thing on your mind at parties? Let me guess… not so much, right? I’m in the same boat, taxes don’t get me hyped. For most of us, taxes are one of those things that are just there, and mostly we don’t think about them too much.

Here’s some great news. As real estate investors, taxes don’t have to be a high priority on our minds. Why? Because the tax code is written to favor real estate investors on purpose. Investing in real estate can actually LOWER your taxes instead of increasing them. It’s true! This is yet another benefit of real estate investing compared to the stock market.

The Disclaimer – you knew it was coming

I am not a CPA. You likely already knew that if you read the first paragraph above. Real estate is my passion. Taxes, not so much! Everything written in this article is from my experience and perspective. Everyone has a unique tax situation. You will want to consult with your CPA or tax adviser to get advice on your specific tax situation.

Now on to the good stuff!

7 Items You Should Know About Real Estate Investing & Taxes

The tax code favors real estate investors (yes, really!)
Passive investors get tax benefits too
Depreciation!!
Cost segregation for the extra tax reduction
Capital Gains is something to plan for. So is depreciation recapture.
1031 exchanges can defer taxes indefinitely
Some individuals invest in real estate SOLELY for tax benefits. They are that good!

#1 The tax code favors real estate investors (yes, really!)

You may have heard real estate investing is a way to reduce your tax burden. It’s true. There’s good reason the IRS tax code is set up this way. Real estate investors provide housing and buildings for businesses to rent. This is really important and the government wants to incentivize individuals to provide this housing. A great way to incentivize is through the tax code.

#2 Passive investors get tax benefits too

You are probably interested in passive investing for many reasons, some of which may include that you don’t want to handle leaking toilets and tenant calls. Great news. Even though as a passive investor you aren’t the one handling the hard work of real estate investing, you still get the full tax benefits.

As a passive investor, you are investing in an LLC that owns real estate. LLCs in the eyes of the tax code are ‘disregarded’ or ‘pass-through’ entities. Those are terms that mean the tax benefits of the LLC flow directly to the owners of that LLC.

Property maintenance, repairs, and other costs associated with the property are written off as expenses.

Real estate investors can even write off the value of the property itself over time, which is called depreciation. This is a big one. Let’s talk about it next.

#3 Depreciation

Depreciation is VERY powerful and is a major reason some individuals invest in real estate.

In life, items tend to have a useful life. A pair of gym shoes may last a year, for example. After a year, I need to get new ones to prevent strain on my knees. ( This is a real example for me and I feel old just writing it!)

Even though real estate lasts a very long time and generally goes up in value (particularly in the hands of investors with a business plan), the value of the asset is still treated as if it’s losing useful life each year.

For residential real estate, the IRS allows you to write off the value of the property over 27.5 years. For commercial real estate, it’s 39 years. I use the word property, which actually means everything except the land. The land value isn’t included in depreciation since land doesn’t have a useful life.

Time for an example

You purchase a residential property for $1,000,000. The land value is $200,000. That leaves $800,000 in building value to be depreciated.

With straight-line depreciation, this $800,000 building has a useful life of 27.5 years, so the $800,000 is equally split over the 27.5 years. In each of those 27.5 years you can write off $29,091 in depreciation. ($800k / 27.5 = $29,091).

As you may have picked up, depreciation has nothing to do with the actual cash flow of the asset. No matter how much money the property actually makes, you still get this depreciation tax expense.

Let’s say the property makes $15,000 in cash flow the first year you own it. Because the depreciation for each year is $29,091, which is higher than the cash flow for the year of $15,000, you get to report a tax loss for the property in this year even though you actually made $15,000.

You pay no taxes on that $15,000 in cash flow this year. It’s all deferred until the property is sold.

See how this is so powerful!? It almost makes taxes exciting!

It’s very important to chat with your CPA on this since everyone’s tax situation is unique.

#4 Cost Segregation for the Extra Tax Reduction

Hopefully depreciation got taxes at least a little exciting. And there’s even MORE good news. We can take this depreciation thing a step further.

I mentioned above straight-line depreciation is either 27.5 years for residential or 39 years for commercial properties. What if there was a way to depreciate even more than 1/27.5 of the value of the building in any given year?

You guessed it. Thanks to cost segregations, this is possible.

Cost segregation breaks out the pieces of the building into their various useful lives. Not everything has a useful life of 27.5 years. For example, a roof may have a longer useful life than carpet. Certain items in the property can be depreciated over shorter timeframes such as 5, 7, or 15 years instead of the longer 27.5 or 39 years.

Taking the value of these pieces of the asset and depreciating them more quickly increases the depreciation benefits early in asset ownership.

If you or a spouse can qualify as a real estate professional, you can even use the tax losses created by depreciation to offset active income such as your W-2 income, side hustle, or business income. (Always check with your CPA)

#5 Capital Gains is something to plan for. So is depreciation recapture.

Alright, we’ll come back down to earth now! We can’t invest in real estate 100% tax free!

Two ways the IRS makes money with real estate is through Capital Gains on the sale of the asset as well as recapture of the depreciation losses on sale of the asset, depending on the sale price.

Both of these items come into play for the tax year in which the property is sold, not during the hold time of the asset.

The specific amount of capital gains and depreciation recapture depends on how long the asset was held as well as your individual tax bracket.

Check with your CPA to see what your brackets are and to discuss specifics.

#6 1031 Exchanges can defer taxes indefinitely

Above I noted capital gains and depreciation recapture can be owed upon sale of the asset. One way to get around this is through a 1031 exchange.

A 1031 exchange allows you to sell one investment property, and, within a specific time frame, swap that asset for another like-kind investment real estate asset.

When you do a 1031 exchange, you continue to defer taxes owed as they are rolled into your next investment. You also move the proceeds from the sale into the purchase of the next asset instead of getting paid out right away.

Many real estate syndications don’t offer 1031 exchanges. If you are looking to go this route, check with the syndication sponsor.

#7 Some individuals invest in real estate purely for the tax benefits

The tax benefits of owning real estate are so incredible, many wealthy individuals invest in real estate purely for the tax benefits. Same with many high income earners.

By investing in real estate, you can take the significant write-offs and apply them to other taxes you may owe, decreasing your overall tax bill.

This is perfectly legal, and is something the IRS wants us to take advantage of! It’s a powerful wealth-building strategy.

You don’t have to be wealthy to take advantage of the tax benefits of investing in real estate. The tax code makes the benefits of investing in real estate available to every real estate investor.

In Summary

There are some compelling tax benefits to investing in real estate. You might not be ready to talk about them at your next dinner party, but hopefully this has you at least a little jazzed about the powerful wealth building strategy of real estate investing.

Here are the 7 things I covered:

The tax code favors real estate investors (yes, really!)
Passive investors get tax benefits too
Depreciation!!
Cost segregation for the extra tax reduction
Capital Gains is something to plan for. So is depreciation recapture.
1031 exchanges can defer taxes indefinitely
Some individuals invest in real estate SOLELY for tax benefits

As a passive investor, you don’t have to qualify for these advantages. You get them for being part of the ownership of real estate, even if you aren’t the one actively managing the real estate. That’s pretty amazing! You don’t have to keep tabs on repairs or manage receipts. You just get a single K-1 at the end of the year to hand to your CPA.

If you’re interested in passively investing, make sure you join our Investor Circle to be notified of any investment opportunities we have now or in the future.