Whatever your financial goals are for your real estate journey, it’s important ot understand the different factors at play on your way to meeting them. It’s not just about how much you can save when buying a property, reducing your operating costs, and maximizing your income. For instance, taxes can eat up a lot more of your cash flow than you might realize, meaning that ignoring your potential tax management strategies can be a very financially irresponsible move. Here, we’re going to look at how your taxes can impact your investment and profit potential, as well as some moves you can pull off to better your financial outcomes.
Start With Your Deductible Expenses
Perhaps the easiest and best place to start is with a better understanding of your deductible expenses. It’s easy to miss out on them simply by not tracking or categorizing your costs effectively. Make sure that you keep records of all expenses, such as repairs, maintenance, property management fees, insurance, legal and accounting services, marketing, and even travel (when it’s related to managing or overseeing your property). There are differences in what counts as an expense versus a capital improvement that you should learn, but with the help of a tax accountant, you can ensure that you’re making the best use of the money you spend on the property, reducing your tax bill at the same time.
Use The Qualified Business Income Deduction
If you’re eligible for it, the Qualified Business Income (or QBI) deduction could reduce your overall taxable income by up to 20%. Qualifying for this deduction depends on a range of factors, however, such as how personally involved you are in managing the property, how many properties you have, and which services you provide to tenants. You don’t qualify simply by owning an investment portfolio. However, many property owners structure their real estate business in a way to ensure that they can apply for the deduction when they make enough income from real estate to make it a viable option.
Take On A Real Estate Professional Status
Although related to QBI deductions and using a similar kind of concept, a Real Estate Professional Status (or REPS) is a separate and distinct tax rule. It makes clear the difference between real estate as a passive investment vs. a non-passive activity, which, in turn, allows you to deduct passive losses against other income like wages or your business earnings. Qualifying to be treated as a REPS requires meeting strict time requirements, even more than a QBI deduction, so it’s not always a viable strategy. However, if you’re already spending over 50% of your working hours managing property investments, it’s worth looking into.
Understanding The Role Of Depreciation
Depreciation, the loss of value in the assets you own, is often considered a negative outcome for an investment, but that’s not always the case with real estate. It can become one of the most valuable benefits available to you, in fact, as it allows you to deduct a portion of the property’s value from your tax bill each and every year. In fact, depreciation can be calculated against your taxes even in years when the property is gaining value. Make sure that you are calculating depreciation correctly, applying it consistently, and keeping it in mind with your broader financial goals to improve your cash flow, especially right after tax season.
Accelerating Depreciation Where It Applies
Making good use of depreciation isn’t just about calculating it and remembering to count it as a deduction on your taxes. You can potentially accelerate some deductions into the early years of property ownership, allowing you to deduct more from your taxes now. One particularly useful example of this is the cost segregation strategy, which identifies specific components of a property that are eligible for faster depreciation, then categorizes them so that their depreciation is tracked separately. This can reduce your taxable income during your high-earning years, improving your cash flow early so that you can either build the reserves that provide a safety net throughout the property’s lifecycle or reinvest to improve its value. Depreciation acceleration isn’t the right strategy for every investment. However, when used right, it can make for serious after-tax returns.
The Tax Implications Of Your Exit Strategy
You should be thinking about how to manage your taxes well beyond your year-to-year tax payments. You should ensure that you’re considering how they can affect even your exit from a property investment. If you start a sale without planning for your taxes, then the capital gains and depreciation recapture taxes can lead to serious costs on your end, deflating your gains. You can instead look at tools like a 1031 exchange, which allows investors to defer their taxes by reinvesting the money made from a sale into another qualified property. If you intend to keep investing in real estate after selling one property, then you can time purchases to align with when you sell the previous one to make sure that you don’t lose money unnecessarily to ownership end taxes.
The importance Of Strong Recordkeeping
Without the right documentation, none of the tax strategies above will work to the degree that they should. You have to make sure that you’re keeping accurate records of any income, expenses, and property improvements to ensure that you’re not only able to maximize your deductions, but that you’re better able to defend them if you’re ever audited by the IRS. If you’re not able to produce the records you need, it could lead to some expenses being reclassified or even expensive penalties. Digital tools and professional bookkeeping can simplify this process.
The various tax implications you should consider and strategies you should employ are going to differ greatly depending on the nature of the property, as well as your own status as an owner (such as whether you own it as an individual or an organization). However, the tips above should get you exploring the various ways that taxes can make a big difference in your real estate investment outcomes.