Investing in real estate continues to be one of the best ways to build wealth and cut taxes. Benefits include the ability to recover the cost of income-producing property through depreciation, to use 1031 exchanges to defer profits from real estate investments, and to borrow against real estate equity to make additional investments or for other purposes.
Additionally, homeowners can benefit from the personal-residence exemption, which shields profits on the sale of a personal residence from capital gains taxes, as well as the deduction for mortgage interest. Read on to find out whether one or a combination of these strategies is right for you.
1. Using Depreciation Deduction
You can recover the cost of income-producing rental property through annual tax deductions called depreciation. The Internal Revenue Code defines the depreciation deduction as a reasonable allowance for deterioration, wear and tear, and a reasonable allowance for obsolescence.
Real estate investors generally use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS), in which residential rental property and structural improvements are depreciated over 27.5 years, while appliances and other fixtures are depreciated over 15 years.
Depreciation expense often results in a net loss on investment property even if the property actually produces a positive cash flow. This loss, as well as expenses, such as utilities and insurance, are reported on Schedule E, federal income tax Form 1040, and deducted from ordinary income.
2. Taking Advantage of 1031 Exchanges
The 1031 exchange, named for Section 1031 of the Internal Revenue Code, allows investors to defer taxes by selling one investment property and using the equity to purchase another property or properties of equal or greater value. This exchange must occur within a specified period of time.
Although a 1031 exchange can broadly include various types of property, the vast majority of transactions relate to real estate. And from Dec. 31, 2017, onward, Section 1031 “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.
Property Regulations
In order to successfully complete a 1031 exchange, the properties must meet the following criteria:
- The aggregate value of the replacement properties must be equal to or greater than that of the relinquished properties.
- The properties included in the transaction must be like-kind, meaning real property cannot be exchanged for some other type of asset, such as a real estate investment trust (REIT).
- Both properties must be held for “productive purposes in business or trade” (an investment).
