Understanding the Tax Advantages of Real Estate Ownership

Real estate has long been a popular investment vehicle, and for good reason. Not only does it offer the potential for long-term appreciation and steady cash flow, but it also comes with a host of tax benefits that can significantly enhance your overall returns.

Whether you're a homeowner looking to maximize the tax benefits of your primary residence or an investor seeking to optimize your real estate portfolio, it’s important to understand the tax advantages of real estate ownership.

Primary residence tax benefits

Owning a primary residence comes with several significant tax advantages. Here are some of the key benefits to be aware of:

Mortgage interest deduction

One of the most well-known tax benefits of homeownership is the ability to deduct mortgage interest. If you itemize your deductions, you can generally deduct the interest you pay on up to $750,000 of mortgage debt (or $1 million if you purchased your home before December 15, 2017). For married couples filing separately, the limit is $375,000 each. If your mortgage debt exceeds the limit, you can only deduct a portion of your interest.

Property tax deductions

In addition to mortgage interest, homeowners can also generally deduct their property taxes. However, the Tax Cuts and Jobs Act of 2017 introduced a new limit on the deduction for state and local taxes (SALT), including property taxes. The limit is $10,000 for married couples filing jointly and $5,000 for married filing separately.

For homeowners in high-tax states, this limit can be a significant constraint. However, there may be strategies to optimize your SALT deduction, such as alternating between itemizing and taking the standard deduction each year.

Capital gains exclusion

Perhaps the most powerful tax benefit of owning a primary residence is the capital gains exclusion. When you sell your main home, you can exclude up to $250,000 of capital gains from your taxable income if you're single, or up to $500,000 if you're married filing jointly.

To qualify for the full exclusion, you must have owned the home and used it as your primary residence for at least two of the five years prior to the sale. If you don't meet these requirements, you may still be eligible for a partial exclusion if you sold due to a work-related move, health issues, or other unforeseen circumstances.

Investment property tax benefits

While the tax benefits of owning a primary residence are significant, the tax advantages of investment properties are even more powerful.

Depreciation benefits

One of the most significant tax benefits of owning investment property is the ability to deduct depreciation. Depreciation allows you to deduct a portion of your property's value each year to account for wear and tear. This can significantly reduce your taxable income from the property.

For residential properties, depreciation is generally calculated over 27.5 years, while commercial properties are depreciated over 39 years. However, there are strategies to accelerate your depreciation deductions, such as using component depreciation to depreciate certain parts of your property over shorter timeframes.

It's important to note that when you sell your property, you may need to "recapture" some of your depreciation deductions, meaning you'll be taxed on them at ordinary income rates. However, there are strategies to defer or minimize this impact, such as using a 1031 exchange.

Deductible expenses

In addition to depreciation, investment property owners can deduct a wide variety of expenses associated with owning and operating their properties. These can include:

• Mortgage interest
• Property taxes
• Insurance
• Utilities
• Repairs and maintenance
• Property management fees
• Professional services (legal, accounting, etc.)
• Travel costs associated with managing the property

Carefully tracking and categorizing your expenses can help you maximize your deductions.

1031 exchange opportunities

Named after Section 1031 of the tax code, this provision allows you to defer capital gains taxes when you sell an investment property and reinvest the proceeds into a similar property.

To qualify for a 1031 exchange, you must identify your replacement property within 45 days of selling your original property and close on the new property within 180 days. The properties must also be "like-kind," meaning they must be of the same nature or character, but not necessarily the same grade or quality.

Pass-through deduction (Section 199A)

The Tax Cuts and Jobs Act introduced a valuable deduction for real estate investors. The Section 199A deduction allows qualified business owners, including real estate investors, to deduct up to 20% of their qualified business income.

For real estate investors, this means you may be able to deduct 20% of your rental income, subject to certain limitations and phase-outs based on your total taxable income. This deduction can significantly reduce your effective tax rate on rental income.

Advanced tax strategies for real estate investors

While the benefits we've covered so far are available to most real estate investors, there are also some additional strategies that can offer certain tax advantages. Here are a few to consider:

Cost segregation studies

A cost segregation study is a detailed analysis of your property that identifies components that can be depreciated over shorter timeframes than the standard 27.5 or 39 years. By accelerating your depreciation deductions, you can reduce your taxable income in the early years of ownership.

Cost segregation studies can be particularly valuable for properties with significant personal property or land improvements, such as multifamily buildings or commercial properties. However, they do require an upfront investment and should be performed by qualified professionals.

Opportunity zones

Created as part of the Tax Cuts and Jobs Act of 2017, Opportunity Zones are designated areas where investors can receive significant tax benefits for investing in real estate or businesses. By investing capital gains into a Qualified Opportunity Fund (QOF), investors can defer and potentially reduce their capital gains taxes.

Real estate professional status

For real estate investors who spend significant time managing their properties, qualifying as a "real estate professional" for tax purposes can offer major benefits. Real estate professionals can deduct their rental losses against their ordinary income, rather than being limited by passive activity loss rules.

To qualify as a real estate professional, you must spend more than 750 hours per year in real property trades or businesses, and more than half of your personal services must be performed in these activities. You must also materially participate in each rental activity.

What both homeowners and investors should consider

Whether you're a homeowner or real estate investor (or both), strategic planning can significantly impact your tax benefits and overall returns. Let's dive deeper into key considerations that can help you maximize the advantages of real estate ownership.

Think long term

Real estate is typically a long-term investment, whether you're living in your primary residence or holding rental properties. It’s important to consider your real estate holdings in the context of your long-term financial goals.

For homeowners, this might mean considering how long you plan to stay in your home, and how your home equity fits into your overall wealth picture. You might also consider strategies like downsizing in retirement or using a reverse mortgage to access your equity.

For investors, long-term planning involves considering your exit strategy, whether that's selling properties for a profit, holding them for ongoing cash flow, or transitioning them to your heirs. It also means thinking about how your real estate fits into your broader portfolio and risk tolerance.

Debt management

Debt is often a significant component of real estate ownership, whether it's a mortgage on your primary residence or financing on your investment properties.

For homeowners, this might involve making choices like whether to pay off your mortgage early, refinance to a lower rate, or use home equity for other investments. It's important to consider the tax implications of these decisions, such as the deductibility of mortgage interest.

For investors, debt management involves finding the right balance of leverage to enhance your returns while not over-exposing yourself to risk. It might also involve refinancing to pull out equity for new investments or using debt to rebalance your portfolio.

Keeping records

Meticulous record keeping is essential for both homeowners and investors to take full advantage of real estate tax benefits. This includes tracking your cost basis, improvements, expenses, and use of the property.

Good records can help you substantiate your cost basis and improvements, which can reduce your capital gains when you sell. They can also help you determine if you qualify for a full or partial capital gains exclusion. Records are crucial for maximizing your deductions and ensuring you're depreciating your property correctly. They're also essential in the event of an audit.

Real estate ownership offers a wealth of tax benefits. However maximizing these benefits requires some advanced planning.

At Range, we understand the complexity of owning real estate. Our platform is designed to simplify the process, with tools for tracking your investments, optimizing your deductions, and visualizing your tax implications. And our team of experts is always available to provide personalized guidance whenever you need it.

‍