It is a common saying that “a dollar saved is a dollar earned,” which perfectly applies to rental property taxes in California. While diversifying your real estate investment is a smart move that can produce a valuable and recurring cash flow, it also comes with tax benefits that help you cut down on your rental expenses by thousands of dollars annually. The longer you rent your property, the lower you will be charged in taxes when you decide to sell.
But if you are unaware of these tax benefits, you are paying extra money that you can add to tax write-offs. Hence, learning about different tax benefits is crucial to take full advantage of them and build significant long-term profit by mitigating or skipping certain tax obligations.
As experienced property managers at California Pacific Realty, we present an overview of real estate tax deductions you can use year-to-year.
One significant financial perk of real estate investing is the tax deductions you can take. That is because the California government allows you to deduct all expenses directly associated with the operation, management and property maintenance. Here are a few of them.
You can define deprecation as an incremental loss of your asset’s value due to assumed wear and tear. You can deduct it as an expense on your taxes if you rent your investment property, which means you can lower your taxable income and decrease your tax liability.
The IRS states that rental properties have a productive lifespan of 27.5 years. So, as the property loses value each year, you can get back the cost through depreciation, which involves deducting a portion of the price of your property over several years.
You can use this formula to calculate your depreciation expense.
Depreciation expense = Actual property value divided by 27.5 years.
For example, suppose you purchase a home you intend to rent, and the value of the building itself is $300,000. If you divide that value by the 27.5-year expected lifespan of the dwelling, you can deduct $10,909 in depreciation every year.
Interest payments are another huge deductible expense for you as a property owner. It means you can write off your mortgage interest payments, home improvement loan, and credit card interest on products and services you used in your rental property. However, it only covers the interest payments, not your monthly loan payments.
Maintenance & repair expenses
Any maintenance and repair cost that boosts the value and state of your real estate investment counts as a deductible. Provided that they are reasonable and necessary. Ordinarily, these expenses include repainting, fixing gutters or floors, plumbing, cleaning costs, plumbing, electrical repairs, broken window replacements and so on. However, you must write off these expenses in the year you incur them.
As a rental property owner, you have an entitlement to a tax deduction on all your travel expenses due to rental activities. However, you must be wise while deducting travel expenses, as the IRS may ask for proof of these expenses. You can deduct costs whenever you travel to deal with tenant issues, collect rent, deliver supplies, or purchase spare parts for a rental repair task.
Fuel costs, airline tickets, vehicle repairs, hotel accommodation and meals during the journey can also be travel expenses. You can also write off vehicle-related expenses using the standard mileage rate per the IRS or as the actual expenses associated with repairs, upkeep, and gasoline.
Home office deductions
If you own a home office to manage the operation of your rental property, all the expenses associated with maintaining that office count as deductibles. Whether you own the office unit or rent it from the landlord, this write-off applies in both cases.
You can deduct the insurance premiums you pay for your rental activity as a real estate investor. It includes theft, fire, flood, and landlord liability insurance for rental property. If you hire employees, you can even deduct the cost of their health and compensation insurance.
Utilities & employers’ salaries
Managing all those units yourself can be challenging if you are an established investor with a strong portfolio of 100+ rental properties. You might hire employees to help you through the management process. The good news is whenever you hire an employee to perform services for your rental property, you can show their wedges as a rental business expense, even if the worker is an employee or an independent contractor.
Professional and legal services
All the expenses that you generate to hire attorneys, real estate investment advisors, accountants, and property managers are tax deductibles. There comes a time when you spend money to hire all these professionals to manage your business, which you deduct later to lower your tax obligations.
However, all these expenses must be for only rental property-related activities, like hiring a lawyer to help you with tenants evictions, an accountant to manage your property’s accounts and property management companies to care for your rental property.
You can deduct the cost of personal property you use in rental activities, including furniture, appliances and gardening equipment. The cost is usually deducted in one year using the 100% bonus depreciation or the minimum safe harbor deduction (for property costing up to $2,000).
If you are a self-employed individual, you must pay the employer and employee portion of the FICA tax, including social security and Medicare. However, your profit does not classify as earned income if you own a rental property.
It means the rental income is not subject to these FICA taxes. Even if you are self-employed, any income relating to a rental property is immune to the social security and Medicare taxes you would otherwise pay on a 1099 or W-2.
For instance, suppose you own any business that generates $50,000 in revenue. Since the government considers that money as earned income, you’re eligible for the payroll tax. At a 15.3% tax rate, you’d have to give $7,650. But, if you’re a rental property owner instead, you can keep that cash in the bank.
Taxes on 1031 Exchange
According to the Internal Revenue code’s Section 1031, you can exchange your rental property for another similar property. A qualifying exchange will have either little or zero tax liabilities, unlike most asset exchanges that are taxable at the time of selling. The 1031 exchange allows you to pass on your capital gains from your existing rental property to another without paying taxes until you sell it.
It means you only have to pay the capital gains taxes upon finally selling a property that includes no swapping. However, there are a few conditions you have to meet to qualify for this tax benefit, such as
- Both properties (the new and the old) must be similar or considered “like-kind.”
- The new property’s value must be greater than or equal to the value of your existing property.
- You should not keep either of the properties for personal use.
- You should use the new property for business purposes only.
Introduced by the US Department of Treasury, opportunity zones are disadvantaged or low-income tracts of land. According to the 2017 Tax Cuts and Jobs Act, investors can put their money into developing these communities by offering tax breaks. Also, as real estate investors, you place your unrealized capital gains into a Qualified Opportunity Fund that goes toward improving the selected area. If you follow the program’s rules, you can enjoy the tax advantages below
- Defer paying capital gains until 2026.
- Grow your capital gains by 10% if you hold the fund for five years (15% for seven years).
- Skip paying capital gains entirely if you remain invested in the fund for 10+ years.
Tax advantages of capital gains
Two types of capital gains tax exist regarding owning or selling investment property – Short Term and Long Term. Each of them impacts your tax situation differently.
Short-Term Capital Gains
When you earn money from selling an asset within one year of owning it, you experience a short-term capital gain. However, selling a property can harm your taxes as the gain gets counted as ordinary income. For instance, if you earn $100,000 from your job and sell a rental property for a $100,000 profit, your income doubles for tax purposes. If you file single, that extra income puts you in the next tax bracket, potentially resulting in a larger tax bill than expected.
Long-Term Capital Gains
Long-term capital gains are the profit investors make from selling the property they have held for more than a year. Unlike short-term capital gains, long-term gains have significantly lower tax rates than the standard income. And if your income is relatively low, you may not even have to pay the tax. For instance, if you make $75,000 per year and file a tax return, the long-term capital gains are tax-free since the tax rate for your income level is 0%. It means you can keep every cent of your profit when selling a property.
An intelligent tax strategy can help you save thousands of dollars each year. However, you must have a sound knowledge of different taxes to claim all tax benefits on real estate investing. One of the sure ways to acquire tax knowledge is to hire a professional property management company like California Pacific Realty. We can help you understand the tax advantages of real estate investing and make sure you have the financial details to make a good purchase.
For more information on tax benefits, contact us at California Pacific Realty.