Experienced real estate investors know that finding (and purchasing) the right property is only the first step in a long process for buying an asset that appreciates in value and produces income.
Once you’ve secured that dream investment, you’ve got to manage it, improve it and, just as importantly, come up with a big-picture tax strategy to protect your profits from Uncle Sam.
Don’t worry — this doesn’t involve burying cash in your backyard or transferring it offshore. These are simple and perfectly legal ways to structure your investments and cash flow to take advantage of the many built-in advantages that the tax code offers real estate investors.
1. Change Your Income
For tax purposes, there are three different kinds of income: earned income, passive income, and investment income.
Earned income (also known as ordinary income) is the money you earn from a business, a job that issues a Form W-2, or self-employment.
This is how most people make most of their money, but it’s also taxed at a higher rate than the other two types of income.
Passive income is money earned through cash-flowing investments such as rental properties, REIT dividends, or a number of other sources.
Depending on its source, this money is generally taxed at a rate slightly less than earned income, and you can reduce your tax liability on passive income through methods such as pass-through entities.
Investment income is the profit you make from selling a property for more than you paid for it. This is taxed as capital gains, which come in two forms: short-term and long-term.
Short-term capital gains are the result of selling a property you’ve owned for less than a year, and these capital gains are taxed at the same rate as ordinary earned income.
Long-term capital gains, however, are assessed when you sell a property you’ve owned for more than a year, as in a buy and hold strategy, and are taxed at a much lower rate than ordinary earned income (0%, 15%, or 20%).
Once you start making real estate investments, you’ll have opportunities to convert your income to the lower-tax types, whether that’s through collecting rent through an LLC or using a 1031 exchange (covered below) to defer capital gains.
The bottom line is that the more you can move away from ordinary income and start earning passive or investment income, the lower your tax liability will be — even as you earn more money.
2. Unleash the Power of the 1031 Exchange
Let’s say you’re finishing up a property sale. You’re filling out your seller’s net sheet, and it’s looking like you’re going to clear a tidy profit — until you get to the capital gains.
Capital gains taxes can take a huge bite out of your investment profits, which is why most investors want to avoid them. Luckily, there’s a way to defer those capital gains taxes indefinitely.
The 1031 exchange is a semi-obscure provision in the tax code that essentially allows real estate investors to “trade” one property for another and defer the capital gains taxes on the sale.
It works like this: Once you sell your initial property, you have 180 days to flip that money into a new property.
You can buy a single new property or multiple new properties as long as they add up to the sale proceeds, and there are few restrictions on what type of property to which you can upgrade.
For example, if you sell a single-family home, you can use a 1031 exchange to reinvest that money in a multi-family rental, a condo you plan to rent or even a commercial property.
You’ll have to use a specialized intermediary to orchestrate the actual exchange, but as long as the transaction takes place within the required timeframe, you’ll be able to defer all capital gains taxes.
Real estate investors appreciate 1031 exchanges. In addition to the tax benefits of using a 1031 exchange, the transaction also contains innate financial advantages.
In particular, the tax-advantaged nature of 1031 exchanges allow you to maximize your compound interest by removing the tax drag seen on paying capital gains.
Much like investing in stocks, you would pay taxes on each sale and over the course of a decade or more, the total value of your nest egg would result in a smaller sum than it would had it avoided taxation.
If you can defer taxes and only pay them on the back end at disposition (sale), you build up equity in a property. This allows you to retain this capital and result in long-term appreciation.
You can also use 1031 exchanges repeatedly so that you defer capital gains through several upgrades of your holdings.
The advantage of this is clear; let’s say you go from a single-family home to a duplex to a multi-unit apartment building to a large commercial property, and each time you used a 1031 exchange.
When you finally sell that property and your capital gains tax bill comes due, you will take a much smaller hit, proportionally, than if you would have had to pay up on the first or second sale.
If a 1031 exchange sounds complex and labyrinthine — most of them require the assistance of a real estate attorney — the arrangement should not scare you away.
Executing a 1031 exchange does not require the expertise of an entire legal team to extract the full savings.
Instead, you can navigate the tax code yourself or use any one of a number of available online options. These firms, the technical term is “qualified intermediary,” make a 1031 exchange easy and affordable.
3. Business Deductions
This sounds like an obvious one, but many non-investors don’t understand just how many business-related tax deductions come available to you once you own real estate.
These deductions include:
- Property management fees (many property management services charge up to 10% of rents, so this can be a sizable deduction)
- Property repairs and capital improvements
- Marketing and advertising expenses
- Legal or professional fees (this includes accounting fees)
- Mortgage interest
- Property taxes and insurance premiums for an investment property (these can’t be deducted on your personal residence)
As you can see from this list, these are substantial costs that can add up fast. You’ll likely need a good tax professional to take full advantage of all the deductions available to you, but it’s worth it.
4. Manage Properly
Speaking of getting a good accountant, this is an area that can trip up a novice investor learning how to start investing money.
Setting up accounts and finding the right person to handle them is one of the least exciting parts of being an investor, but doing this right can pay huge dividends when April 15 rolls around.
To avoid receiving a high bill from your accountant, negotiate your fees upfront. This will avoid the nasty surprise of an unexpectedly high bill.
Further, you should have your accountant commit to some kind of agreed-upon framework to provide better clarity on what you can expect to pay.
Also, with any service you hire, you should also do some comparison shopping to see who has earned the best reviews as well as who offers the best rates. A little time invested upfront can save a lot of time and money in the long run.
If you decide to use a property management company to look after your rentals, make sure you follow the same playbook: Find out exactly what they charge and how much you’re going to pay.
Use Taxes to Your Advantage When Investing
Tax strategizing doesn’t sound nearly as exciting as a new investment strategy, but it can have a huge impact on your returns.
Converting your income streams to more advantageous income types, using 1031 exchanges to defer capital gains, maximizing your business deductions, and finding and locking in dependable tax accountants and property managers all help optimize your long-term investment value in their own ways.
If you can check off all four of those boxes, you’ll be surprised how much more of your income stays in your pocket — and how much less goes to the taxman.