Real estate investors typically see three types of rental property tax benefits:
Benefit # 1: Depreciation Tax Deductions
Federal and state income tax accounting rules allow investors to depreciate real estate improvements (such as the building) over either 27.5 years (in the case of residential real estate) or 39 years (in the care of nonresidential real estate). This depreciation means that even though a property may actually increase in value each year, the investor’s tax return includes a depreciation deduction.
In many cases—but not all—this depreciation deduction saves the investor income taxes. The tax savings occurs because the depreciation reduces either the rental property income subject to tax or offsets other income the taxpayer earns or receives. Note, however, that there are limitations to the use of depreciation to offset other, non-real-estate income.
Benefit #2: Tax-free Appreciation
If a real estate investment appreciates in value, another tax-related benefit is that this appreciation isn’t currently taxed. For example, if you buy a piece of property for $100,000 and the property increases in value to $200,000, the $100,000 gain you enjoy isn’t currently taxed.
That “non-taxability” makes sense to most people. But it’s sometimes a surprise to people that if you can borrow money using the appreciated property as collateral, the combination of appreciation and borrowing still isn’t taxable. Using the case where a property you buy for $100,000 appreciates to $200,000, if you go out and borrow $200,000 against the property’s value, that borrowing isn’t taxed. Even though it’s (sort of) the same as if you’ve sold the property for $200,000 in cash.
Benefit #3: Deductible Business Expenses
A possible third rental property tax benefit that some real estate investors enjoy are deductible business expenses. Here’s how this works: If your principal work activity consists of investing in real estate, you may be able to qualify as what the tax code calls a “real estate professional.” The benefit of being a “real estate professional” is that your real estate activities probably won’t be considered passive investments (which very much limits what you can deduct) but rather as an active business (which basically means you can deduct any ordinary or necessary business expense).
If you have tax planning or preparation questions about your rental property investments, consider calling me. A key part of my tax practice is preparing tax returns for real estate investors and helping them do smart tax planning for their investments. I can supply these services both to real estate investors in and outside of the Redmond, Bellevue, and Seattle area.