Benefits of Investing in Real Estate
It's a fairly well known fact that owning your own home can provide great tax advantages. There are many more tax incentives that come with investing in real estate, however, and these aren't as commonly understood. Investing in real estate has long been a sensible way to accumulate wealth - this article explains why.
Residential real estate investing, defined here as holding property for rent or lease to others, offers a tax deduction for depreciation on the value of a home. This is limited to the value of the actual home, called an improvement, and excludes the value of the land. Condominiums, for example, have no land value and 100% of the purchase price can be depreciated. For tax purposes, a residential real estate investor is able to deduct the depreciation of a property over 27.5 years. Thus, if the purchase price of a home was $27,500 you could deduct $1,000 (27500/27.5) from your taxable income each year for the next 27 years.
In addition, the IRS allows for depreciation on all other types of business equipment and property improvements. This can include things such as appliances, carpeting and other general upgrades to the property or company vehicles and tools used in the operation of the business. The government views investing in real estate much like a small business; it's important that you approach it like a business in order to take advantage of all the tax benefits.
It seems counter-intuitive, but most investment properties go up in value and generate profits every year while their value goes down and they are viewed as a loss on paper. These types of expenses are often termed "phantom expenses" because they produce a paper loss yet don't cost the investor anything. They reduce taxable income, but in contrast to property taxes, mortgage interest, utilities, insurance and repairs, they don't require any cash outlay. The depreciation expense deduction can result in a positive cash flow property becoming a loss for tax purposes.
There is a catch to this attractive loophole; as a part time investor there is a limit to the yearly deduction. This limit is $25,000 if your income is below $100,000 in that year. If your income is over $100,000 this amount begins to phase out and if you make over $150,000 the IRS will not allow you to deduct any loss. These limits, however, are only for those individuals who aren't considered real estate professionals.
The real estate professional designation is given by the IRS. It's given to individuals who qualify by working at least 750 hours, or over 50% of their total working hours, in real estate related activities each year. Full-time real estate brokers, realty sales agents, property managers, builders, contractors and leasing agents are examples of qualified real estate professionals. Anyone else who spends the required time locating, renovating, leasing, or otherwise developing their real estate portfolio also qualifies.
If you can qualify for this designation, you're able to take an unlimited amount of paper loss against your total income. For large investors this can be extremely beneficial!
In order to qualify you'll need to allocate how much time you spend on your regularly paid activities and real estate activities. A qualified real estate activity is anything in which you develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease, or sell real estate. The key is that you're involved in these activities, but you don't necessarily need to perform the work. You could be supervising, meeting or planning; all of the activities that go into running a business qualify (remember I said this should be treated as a business).
As you can see, there are many advantages to owning investment properties. These advantages, combined with the general upward trend of property values, greatly increase the potential for return. Investing in real estate, just like any other investment, requires the proper thought and planning in order to be a success. I would strongly recommend consulting with your CPA about the tax advantages for your situation prior to testing the waters.
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*Please bear in mind that the information supplied in our articles is not engaged in rendering legal, financial, or any other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.
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