There’s little debate about the benefits of
real estate investing. Whether you’re already on a path towards building wealth with real estate or you’re thinking about making your first investment, you know that owning an investment property can be a rewarding opportunity to generate passive income and set yourself up for future earnings.
There’s more to it than collecting rent and paying for the occasional repair or replacement, however. If you own investment properties in Merced, you need to understand what it means for your taxes. There are tax implications that come with owning rental properties, and many investors find tax laws and requirements to be complex.
Luckily, there are plenty of tax benefits to owning rental property. While you do have to declare your rents as income, you also have an opportunity to reduce what you owe the federal government because you’re renting out real estate.
Let’s take a look at what we mean.
Depreciation Benefits and Merced Rental Homes
Let’s start by reviewing one of the best tax benefits enjoyed by rental property owners. This is depreciation, and you’ll find it has a big impact on your tax liability and what you owe.
The IRS allows you to write off the deterioration of your rental property, which leads to a loss of value. The general rate of depreciation for residential homes is set by the IRS at 27.5 years.
To claim depreciation, you must meet some specific criteria, which is pretty standard if you own and rent out a property. You have to prove you’re the owner of the property and you earn rental income on it. You also have to document the useful life of that property, which is a standard 27.5 years (that’s the IRS number). If you begin renting out a home in one year and sell it within that same year, you cannot claim depreciation on that property.
Operating Expenses are Tax Deductible
If you are not already thinking about your rental property as a business, you should be. The IRS sees it that way. It’s a business that earns income
and suffers losses.
Because it’s a business, many of the operating expenses associated with that business are tax-deductible. The most common deductions for operating and business expenses include:
- Property taxes
- Mortgage interest
- Insurance premiums
- Professional property management fees
- Additional professional fees such as accounting or legal costs
- Maintenance and repairs to keep your property habitable
- Travel costs involved in visiting your rental properties
- Home office costs
When you have to spend money on
advertising and marketing costs, those are deductible. When you have to repair a roof, you can write that cost off.
Maintenance costs are deductible on your taxes, but you have to be mindful not to confuse property improvements with maintenance. Those improvements cannot be written off the same way repairs can be. Anything you spend keeping your property safe and habitable is one thing. But, you cannot deduct for new wood floors when you decide to replace your carpet. The IRS does not allow you to deduct the cost of improvements that lead to the betterment of your property value.
Tax Benefit: 1031 Exchange
As you know, the last few years have been great for sellers, with
property values and asking prices higher than they’ve ever been. The hot market has inspired a lot of investors to sell their rental homes in Merced and the surrounding areas.
Selling means paying taxes. That’s a tax implication that pertains to investment properties as well as the home you own and live in. All the profit that’s earned on the sale of your property needs to be reported to the IRS, inviting capital gains taxes.
You can, however, defer the payment of those taxes if you’re willing to re-invest the earnings from your property sale. To defer the capital gains taxes you’ll have to pay on the sale of an investment property, we recommend that investors consider a 1031 exchange. When you take advantage of this tax benefit, you are going to sell one rental property and then use the proceeds to invest in a similar property or a series of properties.
This will not eliminate your tax liability, but it will give you the opportunity to strengthen your investment portfolio and delay paying those taxes.
There are several important steps and timelines associated with a 1031 exchange that we want to share with you to ensure you’re prepared for what this type of transaction entails. Time is of the essence.
- You’ll need to exchange with a like property or properties. The new property you choose must have a value that is the same or higher than the original property. If you walk away from the exchange with any profit, they will be taxable.
- Find one property, two properties, or three to exchange with your current property.
- Pay attention to the timelines. You’ll need to identify a replacement property within 45 days of selling your original property. Then, you have 180 days to close on the new sale. The entire exchange must take place within the 180 days (meaning you don’t have 45 days plus 180 days – the clock does not reset). This can be a challenge now, with the market so hot and inventory lower than the demand. Be prepared to move quickly.
Make sure your property qualifies for this benefit. This tax program is meant for investment homes. You cannot sell the home you’ve been living in and reinvest the money to buy a vacation home. It has to be one income-producing property for another.
When you’re conducting this transaction, it’s necessary to use an intermediary. The intermediary will hold your funds until they can be reinvested in your new purchase. Ask your property managers for a referral if you’re not sure who to work with.
