Here’s why, from a tax perspective, real estate investing is one of the best ways to earn passive income and build wealth:
- The ability to deduct depreciation and expenses (including interest payments) allows you to reduce your taxable income from investment real estate significantly.
- Real estate investors can take advantage of the QBI (Qualified Business Income) deduction introduced by the Tax Cuts and Jobs Act. If you meet the QBI requirements, 20% of your income is automatically tax-free.
- Investors can also avoid paying the self-employment tax (15.3%) by classifying their rental income as “passive income” when they file.
- When you sell a property and use those same funds to purchase a similar kind of investment property, you can use the 1031-exchange program to avoid paying capital gains tax on your profits.
Read on for a more in-depth explanation. We’ll look at the top five tax benefits of investing in real estate and show how owners of short-term rentals can strategically employ these benefits.
The first thing to understand is that you don’t pay taxes on every dollar generated by your short-term rental. You only owe taxes on your net income:
Net income = Revenue - Expenses
Reminder: Revenue is simply the money that comes in the door—it’s the amount paid by your Airbnb guests, plus any other income you might get.
As you can see, when expenses are higher, net income—and therefore your tax bill—will be lower. For this reason, it behooves you to track your expenses with care and deduct everything you legally can. The monthly fee you pay for Guesty? Deductible. The wages you pay your cleaners? Deductible. The property taxes you pay to your county? Deductible. The interest you pay on your mortgage? Deductible (just one more reason to love loans).
The following is a list of expenses permitted by the IRS that a typical Airbnb owner would be able to deduct:
• Auto and travel expenses
• Cleaning and maintenance
• Legal and other professional fees
• Management fees
• Mortgage interest paid to banks, etc.
• Rental payments
For more detail on expenses, see IRS Publication 527 pages 3–4.
If you’re serious about maximizing deductions, creating a separate business bank account and getting a separate business credit card is advisable. Separating business and personal expenses will make it much easier to get organized when it’s time to file.
You may have noticed the absence of certain big-ticket items on that list of expenses—things like a home remodel, a new refrigerator, a bedroom addition, or the purchase price of the property itself. Instead of being expensed in a single year, these large expenditures are depreciated over many years.
Depreciation refers to an asset’s gradual loss of value over time. This loss of value results from aging, obsolescence, and general wear and tear.
When you file your taxes, you can take a deduction based on how much your property has depreciated over the year. For example, if your property is deemed to have depreciated by $10,000, you get to deduct $10,000 from your taxable income.
Depreciation is a “phantom expense,” meaning that you get a deduction without actually spending any money. Depreciation goes a long way to reduce your tax bill, making real estate investments that much more attractive from a tax perspective.
Real property exists as a collection of assets—the land, the landscaping, the building itself, any property inside the building. These asset types are depreciated at different rates, according to IRS rules. To perform a cost segregation, you’ll separate out these asset types, and calculate depreciation for each based on these different depreciation rates.
The amount of time over which an asset depreciates is called its “useful life.” The IRS also refers to this length of time as a “recovery period.” Via its “General Depreciation System” (GDS), the IRS provides a range of recovery periods for different asset types:
- 5 years for computers, office equipment, appliances, carpets, and furniture.
- 15 years for “roads, shrubbery, and fences.”
- 27.5 years for residential property (buildings or structures).
- 39 years for commercial property (buildings or structures).
- 7 years for “any property that doesn’t have a class life and that hasn’t been designated by law as being in any other class.”
It’s important to understand that land has no useful life or recovery period. You can’t depreciate land because land doesn’t wear out or become obsolete. An asset must have a finite useful life to be depreciable; the useful life of land is, in theory, forever.
When you depreciate by the same amount every year, this is known as “straight-line depreciation.” Straight-line depreciation is required for 27.5-year property (IRS Pub. 527 Pg. 10).
By dividing 1 by 27.5, you can find a percentage that tells you the amount by which to depreciate residential property every year.
Example: 1/27.5 = 3.64%. If you have $100,000 worth of residential property, you would be able to depreciate it by $3,640 every year for 27.5 years.
When performing a cost segregation, you will also encounter the 200% declining balance method of depreciation. The 200% declining balance is used for 5- and 7-year property (IRS Pub. 527 Pg. 10). This is a method of accelerated depreciation, which means that assets depreciated with this method will have higher depreciation deductions upfront, and in subsequent years the deductions will go down. There is also a 150% declining balance method, used for 15-year property (IRS Pub. 527 Pg. 10).
Some investors choose not to use cost segmentation, instead treating the entire depreciable portion of their investment (i.e., everything that isn’t land) as a building, then depreciating it over 27.5 years using the straight-line depreciation method. We cannot recommend that you go this route. For any investor serious about maximizing their depreciation deductions, performing a cost segmentation is the way to go. This is because cost segregation allows you to accelerate depreciation and maximize the deductions you take in the first few years of owning the property.
By deducting as much as you can as soon as you can, you’ll have more money left over to reinvest. And because you get the money sooner, it has more time to grow. A dollar today is worth more than a dollar tomorrow, and so it behooves you to take frontload as much depreciation as you can.
If you do some research, you may find that a professionally done cost segmentation can cost over $10,000 and requires the help of an engineer. You can go down that road if you want, but it’s probably overkill for most short-term rental investors. Instead, just keep good records and get a reputable CPA to help you organize your property’s constituent assets into 5-, 7-, 15-, and 27.5-year property, and calculate the corresponding deductions.
Keep in mind that any upgrades to the property will also be depreciable. So if you’re considering new carpet, new floors, or new windows, keep in mind that you’ll get to depreciate these upgrades and lower your tax bill in the process.
Also, note that a property’s assessed value for tax purposes doesn’t always correlate with the property’s market value. As we know, real estate prices tend to go up. That’s a big part of why we’re in the investing game.
The QBI deduction was created in 2017 by the Tax Cuts and Jobs Act. It allows you to automatically deduct 20% of your income if it meets the requirements for “Qualified Business Income” (QBI). You most likely meet these requirements if you own rental real estate (though it is always wise to check with a CPA). For example, suppose your Airbnb generates $20,000 in net income. Subtracting 20% gives you $16,000. With the QBI deduction, you’ll only pay tax on the $16,000 and get $4,000 tax-free.
Avoiding the Self-Employment Tax
W-2 employees (employees of a company) must pay the FICA tax, which funds social security and medicare. This tax is 15.3% but is split 50/50 by the employee and the employer—so each pays 7.65%.
When you are self-employed, you are both the employee AND the employer. Therefore, you must pay both halves of the FICA tax. That’s 15.3% in addition to your ordinary income taxes! This 15.3% tax is called the self-employment tax.
You can avoid the self-employment tax if your income is classified as “passive income.” The definition of passive income includes rents, royalties, and other types of passive cash flow.
Most short-term rental owners will be able to classify their income as passive. The key is to avoid providing what the IRS calls “substantial services.” These include a range of hotel-like services, including room service, valet, and maid service during the guest’s stay. (Maid service between guests does not count as a substantial service.) If you provide these services, your income is no longer passive, and you will be subject to the self-employment tax. Luckily, most short-term rental hosts do not offer these kinds of services.
Avoiding the self-employment tax puts you way ahead. You’re saving 7.65% compared to W-2 employees and 15.3% compared to self-employed people with “active income.”
Capital Gains are Taxed at a Lower Rate Than Traditional Income
One of the most significant tax benefits of owning a short-term rental is one that you won’t notice until you sell a property. When an asset is sold for a profit, whether a stock, a piece of real estate, or a rare coin, the seller owes capital gains tax. The good news for real estate investors is that capital gains are taxed at a lower rate than standard income taxes. Capital gains taxes on real estate are never above 20%, and usually around 15%.
If you plan to stay in real estate long-term and sell one asset to purchase another, you can avoid paying capital gains using the 1031-Exchange program. If you sell a property and use the proceeds to buy a “property similar in kind” within 90 days, the 1031-Exchange program allows you to defer capital gains tax. (“Defer” means that the tax is still owed but has been postponed.) If you eventually wanted to sell for cash, you’d have to pay capital gains tax, but as long as you keep selling real estate to buy more real estate, the tax will continue to be deferred.
Do Your Research
When searching for a rental property, be sure to do your research and understand how the taxes you pay will be affected by the city and state in which your properties are located. Different states, cities, and counties may have their own taxes, and some cities also levy an additional tax on Airbnb hosts. Keep in mind that lodging taxes, while significant, are usually paid by guests and remitted by Airbnb (or whatever hosting company you choose).
Get Professional Advice
Taxes are complicated, and mistakes when filing your taxes can get expensive. You really don’t want to get hassled by the IRS, so it’s best to make sure you do things right. One of the best ways to do this is to enlist the help of a CPA or other tax expert. Look for someone who specializes in real estate, and ideally, who specializes in short-term rentals. You’ll rest easier knowing that you’ve gone over everything with a pro.