Passive real estate investing is becoming more popular these days, with the US housing market being very strong in recent years. The benefits that arise out of investing in real estate are varied and most are not just financial. There is also a range of tax benefits that can be gained when one decides to invest in real estate and reap the rewards through a passive income.
Passive real estate investing is a great way to build wealth. It offers potential for cash flow, appreciation, and tax benefits. For many investors, it’s also a way to avoid active involvement in the day-to-day management of their investments.
Why Real Estate Is a Better Investment Than Stocks
Many Americans believe that real estate is a better investment than stocks. In fact, a 2017 Gallup poll revealed that 35 percent of U.S. adults believe that real estate is the best investment strategy for building wealth.
If you’re deciding whether to invest in real estate or stock, consider these factors:
- Stock market volatility. The stock market is much more volatile than real estate and there’s no guarantee of future returns. The stock market lost about half of its value between 2000 and 2002 and then again between 2007 and 2009; meanwhile, the real estate market is still only just reaching its pre-recession highs.
- Real estate appreciation. Real estate prices have historically gone up at an average rate of 3 percent per year, but they’ve never gone down over the long term. Meanwhile, the S&P 500 has lost money over some 15-year periods in the past century.
- Inflation protection. The stock market doesn’t offer protection against inflation, but real estate can be a hedge against inflation because rent tends to go up as property values rise. Rental income can also increase with inflation because leases typically allow landlords to raise rents over time.
Tax Benefits of Passive Real estate investing
One of the great things about investing in real estate is that you can get tax benefits from it. If you invest as an individual, the IRS taxes the net income your real estate projects generate at your marginal tax rate. So if you’re making $75,000 a year on other income, and you make $25,000 from your rental property income, then you’ll be taxed at a 25% rate on the additional $25,000.
If you incorporate or form an LLC and file a corporate return (or S-Corp), then your entity will be taxed at its marginal tax rate, but distributions to shareholders are not subject to self-employment taxes. Those distributions will be taxed as dividends on your personal tax return, and dividends are currently being taxed at 15%.
However, if you decide to elect to have your entity treated as an S-Corp for tax purposes, then the business income is passed through to your personal tax return and is subject to self-employment taxes.
Passive real estate investing has many benefits, but the tax advantages can be a game-changer for investors. Through a partnership with Fundrise, you can access passive real estate investment opportunities that offer tax benefits unavailable to most investors.
Here are the key tax benefits of passive investing in real estate.
interest payments, property taxes, and maintenance expenses from your income when you’re filing taxes.
Deductions for depreciation – Depreciation is a tax benefit used in passive real estate investing that lets you deduct the cost of acquiring and improving the property over 27.5 years.
The IRS lets owners take an annual deduction for the cost of a property’s depreciation, which is essentially the wear and tear on a building over time. The idea behind this deduction is that buildings don’t last forever, so owners should be able to write off certain costs tied to their upkeep over time.
1031 exchange
The 1031 exchange allows you to sell a property and defer the recognition of capital gains and depreciation recapture taxes as long as you reinvest the proceeds in a similar type of property as part of a qualifying like-kind exchange. Generally, all equity from the sale stays invested in real estate, and no taxes are paid on that equity.
Personal tax deductions
When a property is owned by a limited partnership or LLC, the income taxes flow through to the investors. Depreciation expense, interest expense, and expenses related to the actual operation of the property will reduce the amount of income taxes due on your personal return. This can be a tremendous benefit over other investment opportunities where you pay tax on all gains as they occur (capital appreciation).
Closing cost deductions
Closing costs are deductible with either purchase or sale. While many expenses associated with purchasing real estate are not deductible on your taxes, a portion of your closing costs is deductible.
The IRS considers some closing costs to be investment expenses, which means they can be deducted as an expense in the year you purchase the property. This includes:
- Title insurance fees and other settlement charges
- Recording fees
- Document preparation fees
- Tax service fees
- Attorney fees paid by the buyer
Refinancing costs
Refinancing is the process of paying off your existing mortgage with a new mortgage. The new loan pays off the old loan, and you’ll start making payments on the new loan.
Refinancing has costs and potential benefits. Usually, you’ll want to refinance at the end of an interest rate period in your existing mortgage. For example, if you have a 30-year fixed-rate mortgage at 4.5 percent interest and 10 years are left to pay on it, refinancing can help you secure a lower interest rate. But you might not want to refinance if you’re near the end of your existing loan’s term because it will cost too much money to make it worthwhile.
- Refinancing costs vary depending on several factors:
- The amount of equity in your home
- The type of loan program you select
- Your credit score
- How long you’ve had the existing loan
Gone are the days when passive real estate investing was reserved for billionaires who could spare the time and money to run a large portfolio of rental properties. There are now plenty of opportunities for the everyday investor to enjoy tax-advantaged, property investment growth at an affordable price. As long as there is a good cash flow and strong property appreciation, I would imagine that this approach fits into many people’s retirement strategy and overall financial plan.