Here are some critical investment property tax hacks.

If you use the tax system properly, you could end up never paying income tax on your rent or a capital gains tax on the profit you can make from the sale of a property. If that sounds like a bold statement, allow me to elaborate: 

Let’s say you bought a property for $250,000, then rented it out for a net cash flow of $10,000 a year. Clearly, this is a profit. However, the IRS considers your investment property as a business, and they require you to depreciate the building. There’s a certain formula they expect you to use when calculating that depreciation: the initial value of the property divided by 27.5 years. In our example, your $250,000 property depreciates by roughly $9,000 per year. 

“A 1031 exchange is when you use the profit of your sale to purchase another rental property, in which case you wouldn’t have to pay capital gains tax.”

On your tax returns, you’ll list that depreciation as an expense. Essentially, the money you collect from rent and the annual depreciation will offset each other, allowing you not to pay any income tax on your cash flow. Later on, let’s also say you want to sell that original property and buy another one for $300,000. If you sell it the regular way, you’ll have to pay capital gains tax on the profit. However, you could do what’s known as a 1031 exchange. That’s when you use the profit of your sale to purchase another rental property, in which case you wouldn’t have to pay capital gains tax. Basically, you’re deferring the taxes for later—but that ‘later’ never has to come around. 

Instead of selling that second property for $350,000 and paying 20% on taxes, you can do a cash-out refi. Let’s say the appraisal comes in right at $350,000, and the lender gives you up to 75% of the value. So you get a $260,000 loan. You’d pay the first $200,000, then put $60,000 cash in your pocket to spend however you want. The IRS does not consider refinancing as a taxable event. That’s because the $60,000 you put in your pocket is still owed to the bank. 

What you’re doing is putting a higher lien amount on the property. By pulling the money out, your payment goes up slightly. That’s precisely when the rent should be raised to support the higher mortgage payments. 

If you have further questions on this or any other real estate topic, don’t hesitate to reach out via phone or email. I’m always here to help, and I look forward to hearing from you.