When you enter the world of real estate investments, you are also entering a world of complicated tax laws. Fortunately, these nuanced rules include special tax breaks that apply just to real property. For instance, a major benefit available to property owners is the option to take a depreciation deduction. Depreciation refers to the fact that physical assets deteriorate over time and typically lose value because of this. So if a business or entrepreneur purchases real estate for business purposes, that property will theoretically be worth less the longer the business holds onto it, and the business may have to pour money into repairs in the future. 

The good news is that the IRS factors depreciation into your tax bill and allows businesses to gradually deduct the cost of the property over the years it is owned. What does this look like, and how can you ensure this tax break benefits you? In today’s blog, we will cover the basics of depreciation deductions and tax consequences to consider as a real estate investor.  

Gotta Get that Long-Term Capital Gains Rate

First, a basic rule of thumb when it comes to real estate taxes: you typically need to hold onto a property for at least a year to take advantage of the tax breaks we’re discussing here. Properties held for less than a year before they’re sold will face a short-term capital gains tax. These “gains” (the profit you make when you sell an asset) will be taxed at your ordinary income tax rate, which could be as high as 37%. 

However, if you hold onto that property for a year or more before selling it, any profit you make is considered a long-term capital gain. Now the tax rate can be as low as 0% (depending on your overall taxable income) and no higher than 20%. Plus, if you have owned that property and used it for business for at least a year, you can begin claiming depreciation deductions. 

What’s the Deal with Depreciation? 

When it comes to lowering your tax bill, you can either look for ways to 1) reduce your taxable income or 2) qualify for more tax credits. Depreciation deductions fall in the first category. Owning income-producing property would ordinarily drive up your taxable income, but depreciation lowers it by allowing you to deduct part of the cost of that asset each year. If you hold onto the property long enough, eventually you’ll deduct the full cost of that property!

Some important details to note when it comes to depreciation deductions:

● You must own the property to claim a deduction. You can still owe debt and be in the process of paying it off as long as you are legally responsible to pay for the property, maintain it, and pay taxes on it.
● The property must be used in a “business or income-producing activity.” So this cannot be a property that you just so happen to own but generates no money. If you have a property that has both personal and business uses (like a daycare center that you run from your own home), you might be able to deduct a portion of the value of that space, but you will want to carefully read the guidelines to ensure you are not claiming more deductions than you’re allowed.
● You cannot deduct the entire cost of the property in the year you acquired it or put it “into service,” which refers to the moment you began using it for business purposes. 

One thing to keep in mind: if you own an income-producing property, the IRS will assume you took a depreciation deduction, even if you didn’t. So you might as well claim the deduction and enjoy the benefit! 

Keep an Eye Out for Recapture
There is one potential consequence that could dampen your enjoyment of those depreciation deductions: recapture. Recapture occurs when you sell a property, turn a profit, and the IRS deems that no value was lost on that property during the time you owned it. This means that the depreciation deductions you took are no longer considered valid. Depreciation inherently means that the value of the property is going down—if that is not the case, the IRS will require you to repay any deductions you took. 

The key is simply to be prepared. If you are planning to sell, do your due diligence to determine what you will owe in taxes based on the profit you expect to turn. Working with a professional tax planner can be invaluable here because the answer to “how much will I owe in taxes” can be complicated to calculate. Here’s a quick overview of how it works: the “unrecaptured” gain will be taxed either at your ordinary income tax rate or a special tax rate of 25%. This depends on 1) the year the property was placed in service and 2) how much depreciation your property has undergone at the time of the sale. By working with a Certified Tax Planner, you can simply collect information on when the property was acquired and what tax deductions have been claimed on your yearly returns since then—and trust a professional to calculate the rest.

Investing in income-producing property can come with major benefits and major complications—especially when it comes to tax planning. The best tax strategy for real estate holdings is to think ahead and consider when you might sell that property and what the tax consequences may be. Simply being aware of your options to maximize deductions and minimize recapture puts you ahead of the game when it comes to keeping your tax bill low, both today and for the years to come. To receive expert input on tax planning for your real estate investments,  reach out to a Certified Tax Planner today. 

Don’t miss the rest of our 4 part Real Estate Investment series!