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Creating a Tax Strategy to Maximize Cash Flow
Taxes can be a headache— in everyday life or your investment portfolio. While real estate remains the number one investment choice in the United States,…
Taxes can be a headache— in everyday life or your investment portfolio. While real estate remains the number one investment choice in the United States, a tax strategy is crucial to maximizing cash flow and building wealth. A smart tax strategy involves optimizing your cash flow by reducing liabilities, leveraging deductions, and being proactive in financial decision-making.
Creating a resilient tax strategy should be one of your first priorities as a real estate investor and something you revisit every tax year. High mortgage interest rates, long-term capital gains tax, and economic slowdowns mean it’s never been more lucrative to have a smart tax strategy. The tax benefits of real estate investing make it attractive to potential investors, but understanding how and when to use these tax benefits can be one of the biggest challenges for real estate investors.
At Privy, we equip you with real-time market data and automated deal-finding tools to help you locate profitable investment opportunities, streamlining the process of maximizing your returns and ensuring your tax strategy aligns with your investment goals. Learn how real estate investors can expertly harness their tax strategy to maximize cash flow with every deal.
Understanding Taxes on Real Estate Investments
Real estate investing requires you to identify a good investment property with the best possible return that aligns with your investing goals. Tax liability is something that novice investors often overlook. Before looking at potential tax strategies for real estate investors, it’s important to recap the taxes you’ll pay on your investments.
Four main taxes apply to real estate:
- Income Tax
You’ll pay taxes on the income you generate from rental properties, calculated by deducting allowable expenses from the rental capital generated to determine your net rental income.
- Capital Gains Tax
If you sell an investment property, you’ll be expected to pay capital gains tax. Short-term capital gains tax applies to properties held for less than a year, such as a fix-and-flip property. However, properties held for over a year face a reduced long-term capital gains tax rate. You’ll pay capital gains tax on the profit of the property sale.
- FICA Taxes
Established real estate investors may register their properties as part of a real estate business. In this scenario, you’ll be liable for FICA taxes, including Social Security and Medicare.
It’s important to note that the IRS considers rental income passive income if the investor is not actively participating in the rental property. Therefore, investors would be exempt from FICA taxes. Alternatively, real estate professionals can treat their rental income as non-passive, therefore deducting losses against ordinary income. However, they’ll still be subjected to FICA taxes.
- Property Taxes
You’ll be expected to pay property taxes on all investment properties. However, these are considered an operational expense and are deductible against the income generated by your rental property.
Privy’s access to comprehensive data ensures you have the market insights to make informed decisions about your property investments, which can positively impact the deductions and financial strategies you’ll use to minimize tax liability.
Real Estate Investor vs. Business Owner: Tax Benefits
When you start investing in real estate, it’s important to determine how you’ll finance and structure your investments. These choices can all have different tax benefits or consequences. For example, many investors use a self-directed IRA to invest their retirement funds into real estate, deferring taxes until they retire.
The type of entity you choose to create will determine the tax benefits you can take advantage of. An LLC or S-Corporation enables investors to utilize pass-through deductions, preventing double taxation. LLCs can also benefit from more practical changes, such as being able to pay taxes online.
The activity level an investor has in their real estate will determine whether they are an investor or business owner. Determining where you stand on this distinction early on is important as it affects how passive losses are accounted for and which deductions you can use.
You’ll be considered an investor if you do not actively participate in management decisions. These investors usually invest as limited partners in a fund or through a real estate syndicate. Therefore, they do not make management decisions or have voting rights.
By comparison, a business owner is continuously involved in their investment property. They may hire a property manager and have a relatively passive role in the business. Investors who qualify as business owners can deduct business expenses, whereas passive investors cannot. Most investors will choose to actively participate in their properties and make management decisions to maximize their tax deductions.
Tax Strategies for Maximizing Real Estate Cash Flow
The goal of your tax strategy as a real estate investor should always be to find ways to reduce your tax burden and maximize cash flow. Optimizing deductions and utilizing available tax credits, such as for renewable energy installations, should be the focus of every investor’s tax strategy.
Here are some of the key elements you can incorporate into your tax strategy:
- Deducting Operating Expenses
Always ensure you’re deducting operating expenses, as these reduce your total taxable rental income, lowering your tax burden. Expenses such as marketing costs, property taxes, utilities, insurance premiums, property management fees, and maintenance costs can all be deducted. These expenses can quickly add up and heavily reduce your tax burden.
- Asset Depreciation
Understanding how to navigate property depreciation can lower your tax liabilities with strategies like accelerated depreciation, which helps to reduce taxable income further. ‘Depreciation’ is a type of annual tax deduction defined by the Internal Revenue Code as a reasonable allowance for deterioration, wear and tear, and a reasonable allowance for obsolescence.
Most investors use the Modified Accelerated Cost Recovery System (MACRS) as their depreciation method, under which residential rental properties depreciate over 27.5 years. Comparatively, other fixtures depreciate over 15 years. Associated depreciation expenses result in a net loss, even if the property generates a positive cash flow. Depreciation expenses and loss are reported on Schedule E of federal income tax Form 1040 and are deducted from ordinary income.
However, it’s important to consider the implications of this tax strategy if you’re planning to sell the property. Depreciation expenses can offer a significant tax benefit when renting the property, but depreciation recapture may increase your taxable income when selling the property.
- Cost Segregation Studies
One of the most impactful tax strategies for real estate investors is to conduct a cost segregation study, utilize 100% bonus depreciation, and oversee their investment as a qualifying real estate professional to maximize cash flow. Landlords and long-term real estate investors can virtually zero out their tax liability with cost segregation studies. Commercial properties and multi-family units often use this strategy to boost depreciation.
A cost segregation study accelerates your depreciation deductions, meaning you don’t have to wait 27.5 or 39 years for the depreciation of your investment property. This study can allow you to deprecate qualifying elements and start making improvements within as little as 5 to 7 years. Land improvements will usually qualify for depreciation faster than building elements.
Real estate investors can use cost segregation studies to maximize short-term cash flow and take advantage of depreciation deductions earlier in their investment’s life cycle.
- Repairs vs Capital Improvements
Real estate investors must understand the difference between repairs and capital improvements, including the impact these can have on tax strategies. The IRS considers repairs relevant costs for keeping a property in operating condition. Comparatively, capital improvements add value to the property, prolong its lifespan, or allow it to be adapted to a different use.
Some potential repairs may fall under capital improvements, depending on the decisions you make. If your HVAC system needs repair, upgrading it to a more energy-efficient system is no longer a simple repair but rather a capital improvement to the property.
It can be difficult for even skilled real estate investors to distinguish between repairs and capital improvements. Maintenance costs that you might assume are repairs can become capital improvements if the work goes beyond merely fixing the system.
Why does differentiating repairs vs. capital improvements matter for real estate investors? They’ll directly impact your tax strategy as capital improvements should be depreciated while repairs are deductible.
Examples of property repairs:
- Fixing an air-conditioning system or AC unit
- Patching holes in a wall
- Repairing appliances but not replacing them
- Replacing broken parts of an appliance
- Replacing a small section of roof or flooring
Examples of capital improvements:
- Renovating an entire room, such as a bathroom
- Installing a new plumbing system
- Replacing 30%+ of a building component, such as the HVAC
- Making new additions, such as a deck or pool
- Utilizing 1031 Exchanges
A resilient tax strategy allows investors to defer taxes by using or selling other parts of their portfolio. A ‘1031 Exchange’, using Section 1031 of the Internal Revenue Code, enables investors to defer their taxes by selling an investment property and using the associated equity to purchase another property of equal or greater value. However, this exchange must occur within a specified time frame for Section 1031 to apply.
Since 2018, section 1031 states that “like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment, other than real property held primarily for sale.”
For a property to qualify for a 1031 exchange:
- The properties in the transaction must be like-kind and of the same asset type; for example, the original property cannot be exchanged from a real estate investment trust asset if the original property was not held as such.
- Both the previous and new properties must be held for productive purposes in trade or business, meaning they must be investment properties.
- The aggregate value of the replacement property in the exchange must be equal to or greater than that of the sold property.
Consider Your Exit Strategy for Real Estate Investments
Don’t just think about your tax strategy for when you’re holding the property. Considering your tax liabilities as part of your exit strategy is crucial to maximizing your return on investment. Different exit strategies for liquifying an investment or your entire portfolio will carry their own tax burden.
It’s best to work with a financial professional and real estate expert to choose the exit strategy that best aligns with your investment goals and financial position.
Common exit strategies for real estate investors include:
- Selling the property outright.
- Conducting a 1031 exchange.
- Using a qualified opportunity fund to roll gains into.
- Selling a property to buy a new one and running a cost segregation study.
- Refinancing with a new loan to pay off the remaining debt and extract cash from the property investment.
Monitoring and Adjusting Your Tax Strategy
Your tax strategy for your real estate investments should be reviewed at least once a year. Local and federal tax rules are continuously changing, and it’s important to be proactive and think ahead to minimize your tax burden. Review your tax strategy annually with a financial professional, identifying any new tax benefits you may qualify for.
A growing number of deductions can be made as governments seek to create more sustainable and eco-friendly homes. Don’t forget to incorporate your cash flow forecasting into your tax strategy to ensure it aligns with your long-term investment strategy and goals.
Scale Your Real Estate Investments with Privy
A proactive tax strategy is crucial to maximizing your cash flow and minimizing your tax burden, enabling you to grow your investment portfolio and achieve your long-term goals. It’s important to take active steps to optimize your tax strategy, continuously reviewing it while considering your exit strategy to minimize your tax burden for today and in the future when selling the property.
With Privy, you get the advantage of our powerful tools that help you find profitable real estate investments quickly, so you can focus on growing your portfolio and maximizing your returns. Privy’s automated deal-finding and instant analysis ensure that your investment decisions are tax-efficient and aligned with your financial goals.
Learn more about Privy and get expert advice on growing your portfolio. Ready to get started? Attend an on-demand demo on how to use Privy to scale your real estate investments.