Taxes

taxesAmong other issues to consider when investing in Residential Income Properties are the tax benefits, which are greater than that of almost any other investment. These tax benefits represent only one of the returns associated with investing in Residential Income Properties and property ownership of this kind.

The current tax code contains two major allowable deductions.

The first is the mortgage interest deduction in which the Internal Revenue Service (IRS) allows a deduction of the interest on the mortgage obtained to purchase that specific Residential Income Property. In a sense, the tenants pay the mortgage of the investor, and the investor takes the deduction.

The other allowable deduction is a property depreciation deduction (on the building only, not the land), which provides the investor with a tax shelter. The depreciation deduction is a “phantom” paper expense that reduces taxable profit and may save the investor thousands of dollars. In addition, when a Residential Income Property is sold, the investor saves on taxes by entering into a 1031 Tax-Deferred Exchange transaction. Taxes on the gain are deferred and there are no taxes to pay, assuming the proceeds are used to purchase a “like-kind” property within a certain period of time. An investor may do this over and over, deferring taxes until death, at which point it will go to his or her heirs on a step-up basis and they can cash in if they choose.  The bottom line is that an investor in Residential Income Properties has a way to avoid paying any taxes on accumulated gains by deferring taxes to the future.

The 1031 Tax-Deferred Exchange benefits the real estate investor in significant ways. Commercial, agricultural, industrial, residential or vacant land may all be exchanged. These exchanges originated in 1921 as simple two-party barter exchanges. Over the passing decades tax laws were changed to require exchanges be multi-party transactions. In 1991, the IRS formally defined the role of the “Qualified Intermediary” as an Accommodator or Facilitator.  Every investor who plans to take advantage of 1031 Tax-Deferred Exchange should seek a Qualified Intermediary to properly execute the necessary documentation.

An exchange typically involves a Qualified Intermediary receiving the proceeds of a property that the investor wishes to sell (Relinquished property). The investor then instructs the Qualified Intermediary to purchase the new property (Replacement property) and convey title to the replacement property to the investor. This exchange allows the investor to defer the realization of capital gains on the sale of the relinquished property and grant these funds that would have otherwise gone to pay capital gains tax, to be put toward a greater investment. In addition, an investor is also permitted to defer the 25% tax on the recapture of depreciation taken on an investment property when he or she elects to effectuate a 1031 Tax-Deferred Exchange.

In addition to these major deductions and benefits, there are secondary deductions that make the difference between losing money and earning a profit on a Residential Income Property: repairs, travel expenses between properties either for a short or a long distance, home office, casualty and theft losses, insurance, employee and independent contractor expenses, and more. To summarize, there are many ways to profit from these benefits if one is careful to follow the rules and regulations established by the IRS to qualify. Having a first class Certified Public Accountant (CPA) experienced in real estate matters can save an investor from paying more taxes than necessary on a Residential Income Property investment.

Please note that we are not tax advisors nor are we licensed to practice tax law or prepare tax returns. Investors should consult with a financial advisor or a certified public accountant (CPA).

Photo Credit: woodleywonderworks

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