Tax deductions are one of the greatest benefits to investing in single family homes. The property taxes, maintenance and insurance as well as other fees are all deductible. The other big deduction is called cost recovery, which is also known as depreciation.
The value of the house minus the value of the land is depreciable. The IRS uses a calculation that equates to allowing 27-1/2 years to write off residential real estate. So a typical rental house can deduct $4,000 or $5,000 from taxable income every year on depreciation. The taxable income on a rental house goes way down, so the passive income from your real estate has a lower effective tax rate.
Tax Rates When You Sell
What many investors don’t expect is that when the property is sold, the depreciation that has been deducted for several years can be recaptured and then you have to pay taxes at a 25 percent rate. That is if you’ve held a property for 10 years and deducted $4,000 in depreciation every year, you have a $40,000 taxable event. At a 25 percent tax rate, you’ll be liable for $10,000 in taxes on the recovery of that tax depreciation. In addition to that, the capital gains rate is generally 15 to 20 percent of the gain on your basis or the increase in value.
1031 Exchange Option
The IRS does provide a provision in Section 1031 of the tax code that allows you to exchange the property and defer the taxes. All you have to do is exchange the home for another like/kind property, which is real estate. It can be a single family home, duplex or any real estate providing income. It can’t be for your personal residence or a second home. You need to identify the property you want and use the proceeds from the home you’re selling to buy it. You also need to hire a qualified intermediary to handle the money and oversee the transaction. That won’t be very expensive, and we have handled several of these through the years, so we know who to recommend to handle the exchange for you.I’m not a tax professional and I always advise investors to talk to their tax expert to discuss liabilities. Talk about these questions when you’re thinking about buying or selling real estate. When you’re ready, please contact us at Tri-City Realty Services.