I recently said, “Use Real Estate as Your Wealth Generator,” because I firmly believe real estate is the average person’s path to wealth. And to add even more fuel to this fire, there are substantial tax implications to using real estate.
Before we go further, please read Taxes 101 and Taxes 102. These will give you a solid base on how the rich leverage taxes to their advantage. Now that you have caught up let’s get into the tax advantages of real estate.
I will touch on four tax advantages of real estate and why leveraging these will fast-track you to riches. This article is not meant to be an in-depth guide. There are many of those out there, including ones like this. Also, look into “Rich Dad’s Guide to Investing” for more.
Like the rest of my content, I am writing for the average person. I want everyone to comprehend what I am writing and how all these ideas fit into your overall picture of financial freedom. I am a firm believer that you don’t have to be the best stock market investor, real estate investor, and entrepreneur. However, if you can take each of these professions’ elements, you can combine them into something quite powerful. Let’s get into the tax advantages of real estate.
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1) Deductions. When you set up a real estate rental, it is its own business. Real estate has its deductions, and business has its deductions. Using these two together can be a powerful combination. You will want to hire a certified public accountant and other tax professionals to ensure you are maximizing your tax write-offs. Legally.
2) Depreciation. When you depreciate your real estate, you tell the government that your structure’s value is decreasing, year over year. There is a (complicated) equation for this and a limited amount of years to depreciate, roughly 27.5 years for residential homes. The advantage is that your property is more than likely to increase in value. Don’t worry about the government; if you sell your house at a profit, you will have to pay back your depreciation. You can prevent this as well; see my fourth point.
3) Capital Gains. Capital gains are the profits you make when you sell an investment. Capital gains are taxed at a more friendly rate than earned income. Even better, there is a way to prevent paying any capital gains at all. See below.
4) 1031 Exchange. I will quote the above article so that you can see the exact definition. “Named after Section 1031 in the IRS tax code, a 1031 exchange is a legal transaction that allows real estate investors to swap an investment property for like-kind property. Thereby avoiding capital gains or depreciation recapture on the sale of the property.”
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What does this mean in layman’s terms? You will be able to upgrade your rental property for another one, usually bigger or more expensive. Your capital gains and depreciation recapture will roll into the new property tax-free.
For example, say I had a 6-unit apartment and sold it for a $200,000 profit. I would have a limited time to transfer that money into a bigger apartment, say, a 12-unit apartment building. Sophisticated investors can keep doing this until they have a mega-apartment structure. Their rental income would be increasing with each building upgrade. So, in theory, you could go from $1,000/month passive income to $3,000 to $8,000- all tax-free.
The 1031 exchange is the main reason real investors flock to this investment strategy. It is very friendly to real estate investors. When you own real estate, there are enough deductions and depreciation to ensure that your passive income is taxed at the lowest rates, sometimes even at zero percent. When you finally sell your property, you will more than likely want to do a 1031 exchange and pay no capital gains taxes.
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Why is the government so friendly to real estate investors? This question is the meat of this article. If you understand this, then you will understand why real estate is such a powerful investment tool. The government wants people to keep building homes, commercial buildings, roads, schools, and neighborhoods.
The government knows that non-government employees are more efficient and effective at building out neighborhoods and commercial real estate. To keep the economy going, real estate has to be continually leveraged. Real estate is the driver of the economy. It creates jobs and homes for those new employees.
Think about a crappy neighborhood that you drive by. Eventually, someone will go in there and retrofit the area. Real estate investors will teardown bad homes and buildings and add new neighborhoods, schools, and parks. Once real estate investors build communities, then shopping centers, movie theatres, and commercial real estate will move in.
This where REITs (please read Introduction to REITs) come in. There are REITs for apartments, cell towers, self-storage, commercial real estate, and residential housing. All this comes back to the tax advantages of real estate.
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The government tried its hands in the housing sector, and it didn’t turn out so well. They know that the real estate community can do it faster, better, and cleaner. An entrepreneur’s job is to solve a problem for a profit. Savvy real estate investors find run-down apartments and crunch the numbers. They know that if they can clean up the buildings, add washer/dryers inside the rooms, increase security, and create excellent curb appeal, they will boost their net operating income (profits).
Forced appreciation is why the government favors real estate. The government wants investors to improve buildings and communities- increasing the investor’s wealth and also assisting the government. The more people that the entrepreneur houses, the richer they become. It is a win/win for the government and the entrepreneur. If you ever wonder why entrepreneurs and real estate investors are getting rich, look at how many people they are serving. My wife and I have five tenets, and they are helping us to grow our wealth. In exchange, we provide their housing and we also correct issues promptly.
How many people are you serving? Are you leveraging real estate for its tax advantages? Don’t get angry that real estate investors get so many tax breaks; understand the government’s position. Then take time to create a plan to invest in real estate. Start serving others. Even if you start by renting out rooms, you are adding value to someone else’s life. This can make you rich, improve your quality of life, and build a foundation of generational wealth.
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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