Tax Fact: Nearly 300,000 trees are cut down yearly to produce the paper for all the IRS forms and instructions. Happy Earth Day (just in case you did not know).
Extensions have been filed and refunds are in the mail. As you reflect on the money you paid in taxes in 2015, it’s a good time to think about strategies for the upcoming year (and years to come).
Many of you have thought about, or currently do, invest in real estate. There are two primary tax benefits to real estate investing: (1) treating your property as a business; and (2) 1031 exchanges.
1) Real Estate – Your New Business
Real estate, like any other investment, should be treated like a business. Depending on what you invest in, you might receive rent checks for your single-family home or wire transfers from the local grocery store down the street. In business terms, this would be considered your "Rental Income." To figure out your profitability, we need to subtract your expenses, which with real estate include cash and non-cash payments. Cash expenses include taxes, insurance, maintenance and repairs, landscaping, etc., which are paid directly to other entities such as the county or hired vendors/contractors.
The non-cash expense is depreciation. Depreciation can be defined as the "reduction in the value of an asset with the passage of time, due in particular to wear and tear." For depreciation, although the IRS allows you to expense it, you do not actually need to provide any money to record it. For example:
- $375,000 purchase price of a single-family home in Sacramento
- $100,000 land value
- $275,000 building/improvements
- 27.5 year useful life for single-family residence
- $10,000 a year in depreciation expense ($375K-$100K=$275K. $275K/27.5=$10K)
- $2,000-$4,000 in tax savings (20-40% marginal tax rate) without incurring the cash expense
As long as you properly budget for your rentals, accounting for replacement costs with capital reserves, purchasing a cash flow positive property will be one of the best investments of your life.
2) Sale (1031 Exchange)
In addition to the benefits of treating your rental as a business, the IRS has one of the most favorable tax treatments for the sale of real estate if you do a like-kind exchange under IRC Code Section 1031. In this situation, the IRS permits you to take the proceeds from the sale of property, and roll it into a new investment without having to pay taxes on it if you use the proceeds from the sale to purchase a "like-kind" asset (i.e. new property/properties, timber rights, etc.). By utilizing this benefit, the property owner defers any capital gain taxes and depreciation recapture. To do this, you need to work with the appropriate professionals. MinnGo and our accountant are an excellent resource to explore your options.
If you ever have any questions at all, please do not hesitate to reach out. At MinnGo, we realize that real estate is not something our clients think about everyday. Lucky for you, that is what we live and breath.
Until next time.