Real Estate and Taxes
One of the many benefits of owning cash flow properties is that real estate rent, collected as income, is considered passive income by the IRS and is exempt from FICA taxes, no matter how large it grows! Most earned income is not exempt, and if you happen to look at any standard paycheck, you will see a FICA deduction.
In addition, all expenses for the real estate investment are deductible against the passive rent income. Examples of deductions are:
- Interest expense
- Homeowner's association dues
- Management fees
- Legal fees
- Accounting fees
- and any other expenses paid due to owning and/or renting a property.
The depreciation of the property can also be used as a deduction. After deductions are taken and if your income is zero or a net loss, you will pay no ordinary income tax and under limited circumstances may be able to apply some or all of the loss to offset taxes on your salary. Of course, it is wise to consult a tax professional on your own individual taxes.
For most property owners, interest expenses are the No. 1 deduction during the initial phases of ownership. Many investors finance as much as possible -- up front -- to leverage their initial capital investment. The interest expense declines over the life of the loan, unless of course the loan is refinanced to take out equity. While the interest deductions decrease, the cash flow of the property typically increases as rental rates increase or keep up with inflation.
When the property is sold, the capital gains can be deferred if a 1031 exchange is utilized in the transaction to purchase another "like kind" property. All the closing costs including real estate commissions reduce the taxable gain amount or the cost basis being rolled forward in a 1031 exchange. Furthermore, it's important to note that the sale of a personal residence is exempt from $250,000 (or $500,000 if married and filing jointly) of capital gain if the owner has resided in the home for greater than 2 years.
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