Tax Benefits of Real Estate Investing

Disclaimer: PeerInvest is not a CPA or tax professional and this post is for informational purposes only. Please consult a CPA before acting on the information in this post.

It's tax time! Taxes may not be something you like to do each year, but it's definitely something you want to know how to do right. At PeerInvest we want to make real estate investing as easy as possible while also making sure our investors are informed and knowledgeable about their money. In the spirit of tax season, we will attempt to put out information about real estate accounting and taxation as it implies to you and your investment.

Benefits

Depreciation

What is Depreciation?

Depreciation is often considered one of the most powerful tax benefits of investing in real estate. It allows real estate investors to estimate a life expectancy for the physical property and deduct a portion of the value each year. The purpose is to account for the "self life" of the asset as it breaks down over time.

How Does it Work?

The amount an investor can deduct each year follows the formula:

deduction = building value (excluding land) / average life expectancy

Building value is only the value of the physical structure and not the land it sits on and average life expectancy, as stated by the IRS, is 27.5 for residential property and 39 for a warehouse/commercial property. There are instances where depreciation can be accelerated, but let's keep it simple for now.

Implications for Investors

Simply put, dividends received do not equal income the investors needs to report on their taxes. Depreciation is a non cash expense that helps offset income earned from renting out the property allowing us to still pay out a cash dividend while lowering your tax burden.

Capital Gains

What is a Capital Gain?

A capital gain is simply the difference between your cost basis (initial investment) and the value realized at the time the asset is sold.

How Does it Work?

The best way to explain it is with a simple example, if Investor A purchased a property for $100,000 and later sold it for $150,000 they would have realized a capital gain of $50,000.

Implications for Investors

Capital gains incur a tax burden at the time they are realized. The taxable amount is the gain realized and the tax rate varies based on holding period (short term < 1 year, long term > 1 year) and your tax bracket. As with any investment, capital losses are also possible and can be used to offset other income (we will discuss this later).

Refinancing

What is a Refinance?

In some instances, PeerInvest will refinance the debt if it views it as favorable to its investors and their potential returns. A refinance is when the debtor receives a new loan to pay off an old loan. This is may be done to reduce the interest rate on the debt, change the duration, or cash out equity.

How Does it Work?

For tax purposes, we will only cover cash out refinances used to pull out equity from the property. For example, Property A is purchased for $100,000, improvements have been made and the market has been favorable to the point that he property is now worth $200,000. Instead of selling the property, a cash out refinance is used to pull out the equity and a new loan in the amount of $150,000 is made on the property. The cash out amount is the new loan amount minus the previous loan that is paid off and origination fees.

Implications for Investors

Cash out refinances are not considered a form of income by the IRS, but as a form of new debt. As a result, there are no tax implications.

Mortgage Interest Deduction

Simple and straight forward, interest payments on a property's mortgage can be deducted. Amortizing loans carry higher upfront interest payments which can provide a nice write off early on.

Loss Carry Forward

After all said and done, the deductions may result in a net loss on paper. As we said earlier, dividends received do not equal income the investors needs to report on their taxes. If there is a paper net loss then these dividends are essentially tax free. Any losses can be used to offset other income or be carried forward to offset future gains.