Investing in real estate requires more than a great deal to achieve the best ROI. Understanding smart tax tips is crucial for making informed decisions about your investment property and achieving your personal financial goals. From standard tips like separating your funds to more complex tax concepts like 1031 exchanges, there is a lot to learn to take advantage of the available deductions and tax planning options.
Savvy real estate investors know that buying an investment property isn’t the end of their journey; it’s actually just the beginning. The ultimate success of your investment depends on your ongoing management of the property, not only in a physical sense (repairs, improvements, tenant screening, rent collection, professional property management, among other things), but also on the more abstract financial level of sticking to a wise tax strategy, maximizing depreciation, and leveraging high tech solutions like landlord apps to keep your operation humming along.
These aren’t marginal gains; a sharp tax strategy for your investment property can be the difference between a long, profitable ownership and having to quickly sell the property at a loss. Let’s review some of the basic tenets of tax-smart property management.
Separate Business and Personal Expenses
Keeping your income streams, including those from investment properties, separate and well-defined will vastly simplify your accounting and filing when tax season rolls around. Don’t succumb to the temptation to put all the money into one account and sort it out later.
This means having separate, unique bank accounts for each of your properties. Consider forming an LLC. You should also keep the security deposits secure; don’t simply let them sit in the same account you use for rental income. Your area may have specific laws regarding how these should be handled.
Since you’ll probably be deducting a lot of business-related expenses, get a business credit card and put all your professional expenses on that account. Mixing personal and business funds can create personal financial liability, as well as a general accounting headache.
Segregating your income streams isn’t just good tax practice; it’s a good fundamental business practice. Having a clear, detailed portrait of the performance of each of your investments gives you a more accurate idea of how they’re actually doing, and allows you to reverse negative trends before they worsen. Without careful management, a significant expense or life change might force you to end up dumping your property to an investor for some quick cash.
Get Your Deductions in Order
Investors have a number of tax deductions available to them, and a smart tax strategy takes advantage of all of them. These deductions include:
- Mortgage interest
- Professional fees for lawyers, accountants, property managers, contractors, etc.
- Repair and maintenance costs
- Premiums for liability, property, and other insurance policies
- Utility bills
- Travel and business expenses connected to the investment
Taking advantage of these deductions requires some meticulous bookkeeping and recordkeeping. For example, if you have to consult a lawyer, make sure you get a receipt.
Depreciation is Key
Depreciation is arguably the single biggest tax advantage of owning a property. It’s a simple idea. For a residential rental, the IRS has determined a “useful life” of 27.5 years under the General Depreciation System (GDS). This means each year, you can deduct 3.636% of the building’s value from your taxable income—keep in mind that the land is not depreciable, so be sure to consult a tax advisor to ensure you are making the correct calculations.
Additionally, remember that when you sell the property, you might have to pay taxes on some or all of the depreciation you claimed over the years.
Know the difference between repairs and improvements
While you can claim a tax deduction for repairs you make to your investment property, improvements are deducted through depreciation. You must understand the difference between the two to avoid trouble with the IRS for misfiling.
Repairs are work that keeps the place habitable and in good condition, such as fixing a leaky pipe or replacing a faulty light fixture. Improvements, on the other hand, increase the property’s value; for example, putting in a nicer kitchen or renovating a bathroom.
Consider a 1031 Exchange or a DST to Defer Capital Gains
Unless you’re a “one and done” investor, you’re probably planning on selling eventually and reinvesting in a bigger, better investment. If you fall into that category, you probably know that upon selling your present investment, capital gains tax stands to take a massive bite out of your profits. That is, unless you use a 1031 exchange or a Delaware Statutory Trust (DST) to defer those capital gains taxes, potentially indefinitely.
Both a 1031 exchange and a DST work in a similar manner: an investor who sells a property can then reinvest the proceeds into a 1031 exchange or a DST, deferring their capital gains taxes entirely. That tax bill will come due when they eventually sell, but investors can also use 1031 exchanges repeatedly — selling an investment and reinvesting in something new while continuing to defer capital gains. In theory, an investor who continually reinvests their money through one of these vehicles could defer their capital gains indefinitely. That’s a potentially massive tax savings.
Automate as Much as Possible
In this dawning era of AI, so much has already been automated or is about to be. While we’re not advising you to turn over tax filing and property management to ChatGPT, there are a lot of simple, high (and low) tech solutions that can keep your investment running smoothly and frictionlessly.
Set up automatic payments to take care of insurance premiums, your mortgage payments, and any utilities you’re responsible for paying. On a similar note, consider automating collection by using digital payment services. Landlord apps can streamline and organize your communications with and obligations to your tenants. By taking advantage of accounting software like QuickBooks or using an all-in-one tool for property management, you can automatically track your incoming and outgoing funds, providing a granular, real-time view of your investment’s performance.
Utilize Professionals
Successful investors tend to be confident, take-charge types with diverse skill sets. Add in a hyperawareness of the bottom line, and it’s no surprise that many property investors decide to handle their bookkeeping and property management themselves.
But doing it all yourself can have diminishing returns, and automation can only take you so far – not to mention the fact that accounting oversights or errors can be very costly. Unless you have specific professional expertise that qualifies you to handle every aspect of your property management, it’s probably wiser to hire a professional bookkeeper, tax accountant, and even a property manager. When you were looking for your property, you probably spent time searching for the best low-commission real estate agent in your area; why not access similar expertise now that you’re an owner?
Learn more: Should I Hire a Property Manager or Self-Manage My Rentals?
It’ll cost a little money, but the peace of mind you’ll get from having professionals handle your affairs will be worth it. And best of all, fees you pay for property management and accounting are tax-deductible.