You’ll Appreciate Real Estate Most At Tax Time
Posted on March 16, 2007
Fortunately, the government is smart enough to realize that private property owners make better landlords than it does. If you’ve ever driven by one of those huge government housing projects in New York or Chicago, you understand why the government wants housing to be in private hands. When you own real estate and make it available to renters, you are performing a very valuable service for your community and the government rewards you with some impressive tax benefits for doing so.
Even with recent tax law changes, real estate is still one of the best, if not the best, tax sheltered investments you can own. Although its not the gravy train is was prior to the 1986 tax law revisions, when it could shelter all of the income it produced plus substantial if not all of the income you earned on your job, real estate still enjoys many wonderful tax breaks. In its heyday, people used real estate to shelter incomes in excess of a million dollars a year and paid no federal income tax.
Unfortunately, those glory days are over, but the benefits that still remain make real estate one of the most lucrative assets you can own. Aside from the fact that you can leverage the purchases so that other people buy the properties for you, real estate still offers many great tax benefits. Before I go any further, let me make it clear that I’m not a tax advisor, just an investor willing to discuss the benefits I have experienced first hand. For guidance based on your personal situation, you would be wise to consult a professional tax advisor.
First, let’s discuss the difference between the income you earn on your job and the income produced by real estate investments. Look at your paycheck stub and you will notice a deduction for Federal Insurance Contributions Act (FICA). Not only do YOU pay this tax, but your employer must match too. This is in addition to the wages you are being paid. That’s because earned income is subjected to the FICA tax and there’s no way around it until your income surpasses a certain amount. Both the tax rate and the amount subject to the tax have been steadily rising since the passage of the Social Security Act in 1935.
On the other hand, rents you collect from real estate, no matter how large they grow, are considered passive income and are exempt from both the employee and employer share of FICA taxes. Just this tax break alone is a tremendous reason to own real estate, but the benefits are just beginning.
In addition to the exemption from FICA taxes, you can also deduct all expenses associated with investment real estate to reduce the amount that is taxable. This means you can deduct things like interest expense, management fees, taxes, insurance, repairs, homeowner’s dues, utilities, legal and accounting fees and any other expenses incurred from owning and renting property. You even get to deduct a portion of the purchase price each year in the form of depreciation although the value of the property is probably increasing at a rate greater than the rate of inflation.
If, after taking all of the allowed deductions, your income is zero or you show a loss on paper, you will pay no ordinary income tax and under limited circumstances may be able to apply some or all of the loss to offset taxes on your salary. Here’s where a professional tax advisor may help. There are certain circumstances in which you may be required to pay some Alternative Minimum Tax.
The interest deduction plays an important role, especially when you’re just getting started and cash flows are tight. Most investors finance as much as possible in the beginning; therefore, interest is most likely their largest expense. Over time as the mortgages pay down and rents increase, the interest deductions will decline but the cash flow will increase. When the mortgage is paid off, although there may be some tax to pay, they will get to keep a substantial part of the income because they won’t be paying interest.
There are so many additional tax benefits to real estate it’s hard to do justice to all of them in this limited space. There are ways to sell properties and defer taxes on the profits if you if you reinvest them in additional properties. Even if you don’t reinvest them, if you have owned the properties for at least a year, the profits are taxed at a very favorable capital gains rate which can be less than half the rate for ordinary income. Under the current Internal Revenue Code, you can avoid paying taxes altogether on profits up to $250,000 from the sale of your personal residence and can do it again every two years. (Double that if you’re married and filing jointly.)
Here’s a tip! Fear and ignorance keep more people from building wealth with real estate than any other reason. Granted, if you have some cash and good credit, you have more options than someone who doesn’t, but even without these, there’s no reason to put your head in the sand and let financial freedom pass you by. A bit studying and a little effort can make you the proud owner of an investment property in a few short months. All it takes is the commitment to find a way, not an excuse.
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