Real estate is widely known for potential lucrative investment opportunities that may bring strong returns and the opportunity to build long-term generational wealth. These benefits, combined with many favorable and unique tax benefits that come with real estate ownership, help make it a preferred asset for alternative investment capital allocation.
When considering real estate as an investment, it's important to understand the potential tax-advantaged opportunities that come with direct property ownership:
- Deferral of any realized capital gains taxes by completing a 1031 exchange;
- Income sheltering; and,
- A step-up in basis for the investor's heirs upon their death, which can eliminate any accumulated deferred capital gains.
These tax benefits can provide significant advantages to real estate investors and ultimately may lead to greater wealth accumulation over time.
Keep capital working with a 1031 exchange
A key tax strategy that real estate investors may find beneficial is the 1031 exchange. Exchanges — selling one investment property and reinvesting the funds into another property — can be a powerful tool for real estate investors because it allows them to defer taxes on capital gains and reinvest a larger amount of capital into replacement properties that may offer the potential for greater asset appreciation and increased cash flow.
Investors must adhere to strict IRS guidelines to successfully complete a 1031 exchange. Here are three main aspects of an exchange:
- Like-kind properties. Properties on both sides of the transaction must be "like kind" to qualify for a 1031 exchange. "Like kind" means both properties have the same nature or character and must be held for investment purposes. Properties in an exchange can include different types of residential or commercial real estate so long as they are held as investment properties.
- Timelines. The replacement property must be identified within 45 days of the sale of the original property, and the exchangor must close the transaction on the replacement asset within 180 days. It's important to identify potential replacement properties well in advance of beginning the exchange process to reduce the risk of missing a deadline and voiding the exchange.
- Qualified intermediary. Exchangors can't take receipt of sale funds at any time during the exchange process. They must engage a qualified intermediary to hold sale funds in escrow and purchase the replacement property to complete the exchange.
There are other important exchange rules, such as the regulations about replacement properties, but exchangors can lean on the experience of their qualified intermediary and tax professional to help navigate the exchange process.
Why complete a 1031 exchange?
The 1031 exchange can offer many potential benefits to real estate investors.
Above all, an exchange allows investors to defer capital gains taxes generated from the sale of an appreciated investment property, which can be a significant tax advantage.
Here's an example: An investor buys an investment property for $500,000 but sells the appreciated property for $1 million and realizes a capital gain of $500,000. At a long-term capital gains tax rate of 20%, the investor would owe $100,000 in taxes. However, by reinvesting the proceeds into another property through a 1031 exchange, the investor defers capital gains taxes and has the full $1 million available to purchase another investment property.
Furthermore, by doubling the amount of available investment capital, the investor can potentially "upgrade" properties over time by reinvesting capital into properties that offer greater potential for appreciation and increased cash flow. This can ultimately lead to more accumulation of wealth over time, as investors are able to continually reinvest their capital into properties that offer the potential for higher returns and increased asset appreciation.
Combining the tax deferral and property upgrade strategies may lead to the creation of a significant financial legacy through real estate and provide lasting generational wealth for your heirs.
Other real estate tax benefits
Real property ownership offers additional income-sheltering benefits outside of the 1031 exchange. Real estate investors can deduct a variety of expenses related to their properties, including mortgage interest, property taxes, and depreciation. These deductions can significantly reduce their taxable income and ultimately lead to greater yearly cash flow.
The tax benefits of the mortgage interest deduction alone are significant, since it's one of the largest expenses associated with owning a rental property. Mortgage interest is fully tax deductible, which can reduce a real estate investor's annual taxable income and result in substantial tax savings over time. Property taxes are also deductible, which can further lower tax liabilities.
Depreciation is another valuable tax deduction available to real estate investors. Depreciation allows investors to deduct a portion of the cost of operating their property over a number of years based on the property's useful life — for residential investment properties it's 27.5 years, and for commercial properties it's 39 years.
Real estate in estate planning
Real estate offers a unique benefit for estate planning through the step-up in basis.
After the owner of an investment property dies, the value of their property is "stepped up" to the current fair market value for tax purposes. This means that their heirs wouldn't pay taxes on any appreciated gains realized on the $1 million replacement investment property that completed the 1031 exchange in the example provided above. The heirs don't take the property at the $1 million cost basis, but rather at the property's current fair market value, regardless of whether the original owner held the asset for two years and it appreciated $100,000, or they held it 15 years and it appreciated $1 million.
By transferring properties to heirs upon death, investors can effectively transfer their properties at a stepped-up basis, allowing them to avoid capital gains taxes on the appreciated value of the property. This can be a valuable estate planning tool, as it allows investors to transfer their wealth to future generations without incurring significant tax liabilities.
Putting it all together
Real estate offers several unique tax benefits that help make it an attractive investment class for building long-term wealth.
The 1031 exchange is a tool that investors can use to defer capital gains taxes on the sale of their properties. Exchanges also allow investors to potentially upgrade their properties over time, which may lead to greater potential returns and cash flow.
Income sheltering through deductions for mortgage interest, property taxes, and depreciation can significantly reduce a real estate investor's taxable income and result in greater wealth accumulation over time.
The step-up in basis provides valuable estate planning opportunities for real estate investors since it allows them to transfer their wealth to future generations without incurring significant tax liabilities from deferred capital gains taxes.
Investors who carefully consider the potential risks and rewards associated with investing in real estate and work with financial and estate planning professionals to develop appropriate financial goals and tax strategies may ultimately achieve greater financial success through real estate investment.
The information provided here is not investment, tax or financial advice.
