Tax Benefits of Real Estate Investing 

3. 1031 Exchange

1031 exchanges offer a strategy for deferring capital gains taxes upon selling a property by subsequently acquiring an investment property of equal or greater value. While there is no limit on the frequency of utilizing a 1031 exchange, eventual capital gains tax obligations arise upon selling the property.

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Eligible properties for exchange must be business or investment assets, although exceptions allow for the exchange of a former primary residence in certain cases. Both properties involved must be situated within the United States, and only real property qualifies for a 1031 exchange (excluding equipment, corporate stock, aircraft, etc.). Additionally, if selling interests in an investment as a tenant in common (TIC), the property swap is eligible for a 1031 exchange, provided all other IRS requirements are met.

The IRS imposes timing regulations for 1031 exchanges, including:

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• 45-day rule: Proceeds from the property sale must be transferred directly to an intermediary. Within 45 days of the sale, you must designate a replacement property and furnish written notice of the designation to the intermediary.

• 180-day rule: Closing on the new property must transpire within 180 days of the sale of your previously owned property. This 180-day duration runs concurrently with the 45-day period.

4. Opportunity Zones

Opportunity Zone funds offer real estate investors a mechanism to reinvest proceeds from real estate property sales, thereby mitigating capital gains taxes. Notably, the recent Opportunity Zone program encompasses residential rental property businesses, enabling novice real estate investors with single rental properties to leverage these tax advantages while expanding their rental property portfolio.

Designated by the U.S. Department of the Treasury, Opportunity Zones target economically disadvantaged areas across the country, aiming to attract investor capital for economic revitalization. By channeling unrealized capital gains into a Qualified Opportunity Fund, investors not only contribute to community development but also enjoy significant tax incentives. Investing in a Qualified Opportunity Fund yields several benefits:

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• A 10% increase in capital gains if the investment remains in the fund for five years, escalating to 15% after seven years

• Deferred capital gains tax obligations until 2026 or upon divesting from the fund

• Exemption from capital gains taxes provided the investment remains in the fund for at least ten years

5. Passive Income and Passthrough Deductions

Prior to 2018, passive income, as defined by the IRS as earnings from real estate activities in which the business owner isn't materially involved, couldn't be offset unless the business owner also incurred passive losses. However, changes in legislation have introduced certain provisions allowing real estate investors to deduct a portion of their rental income from their taxable income through what the IRS terms a "pass-through deduction."

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This regulation enables real estate investors to potentially deduct 20% of their qualified business income (QBI) automatically. QBI encompasses revenue derived from rent payments if the property is owned through an LLC or S-Corp, operated as a sole proprietorship, or involved in a partnership. However, certain forms of income such as dividends, capital gains, losses, and interest income do not qualify for this deduction. This pass-through deduction represents a benefit of the Tax Cuts and Jobs Act of 2017 and is currently slated to expire in 2025.

6. Capital Gains Tax vs. Ordinary Income Tax

When a real estate investor sells a property for a price exceeding their initial purchase cost, the resulting disparity may be subject to taxation as either a short-term or long-term capital gain, which typically incurs a lower tax rate compared to regular income tax.

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For properties held for less than 365 days, short-term capital gains are taxed at rates ranging from 10% to 37%, contingent upon the investor's tax bracket. Conversely, if the property was held for a year and a day or longer, long-term capital gains tax rates range from 0% to 20%, depending on the investor's tax bracket. Consequently, by holding a property for at least one year plus one day and having a sufficiently low annual income, an investor may potentially pay no tax on the profit generated from selling a rental property.

7. Tax Free or Tax Deferred Retirement Accounts

Numerous avenues exist for real estate investment beyond conventional property ownership and rental arrangements. By directing funds into alternative assets via vehicles like health savings accounts (HSAs), individual retirement accounts (IRAs), Solo 401(k)s, SEP IRAs, or Self-Directed IRAs, investors can potentially benefit from tax-deferred or tax-free growth on their investments. Integrating real estate investment funds into your portfolio within a tax-advantaged account presents a means to access this potentially lucrative sector while avoiding an increase in your tax obligations.