How to Use Real Estate to Reduce Taxes Effectively

Real estate investment offers a multitude of benefits, with tax reduction being one of the most compelling. For both investors and homeowners, understanding how to utilize real estate for tax advantages can significantly impact financial outcomes.

Mortgage Interest Deductions

Homeowners can reduce taxable income by deducting interest paid on a mortgage. This benefit is particularly useful for those with substantial mortgage balances. Under the current U.S. tax code, interest on mortgage debt up to $750,000 can be deducted for loans taken out after December 15, 2017. For single filers or married individuals filing separately, the cap is $375,000. Staying informed about legislative changes is crucial to understanding how these limits may shift.

The mortgage interest deduction is itemized, meaning taxpayers must choose it over the standard deduction. In 2024, the standard deduction is $27,700 for married couples filing jointly and $13,850 for single filers. Taxpayers should calculate whether their itemized deductions, including mortgage interest, exceed these amounts to determine the most beneficial option.

Property Tax Deductions

Property tax deductions allow homeowners and real estate investors to subtract property tax payments from taxable income. The Tax Cuts and Jobs Act of 2017 capped the deduction for state and local taxes, including property taxes, at $10,000 for both single filers and married couples filing jointly. This cap remains in effect for the 2024 tax year and disproportionately affects those in high-tax states.

Accurate reporting of property tax payments is essential. Homeowners should maintain detailed records, including receipts and tax assessment documents, to substantiate claims on tax returns.

Depreciation

Depreciation enables property owners to reduce taxable income by accounting for wear and tear on their properties. Residential rental properties can be depreciated over 27.5 years, while commercial properties are depreciated over 39 years. This deduction can significantly enhance cash flow and profitability.

The Modified Accelerated Cost Recovery System (MACRS) allows for higher deductions in the early years of property ownership. IRS Form 4562 is required to report depreciation, and non-compliance can result in penalties and interest.

1031 Exchanges

1031 Exchanges, named after Section 1031 of the Internal Revenue Code, let real estate investors defer capital gains taxes by reinvesting proceeds from a property sale into a like-kind property. This is particularly advantageous in appreciating markets, as it allows investors to preserve capital for future investments.

To complete a 1031 Exchange, investors must identify replacement properties within 45 days of selling the original property and finalize the acquisition within 180 days. Qualified intermediaries are required to manage the exchange process and ensure compliance with IRS regulations.

Capital Gains Exemptions

Capital gains exemptions provide tax relief for homeowners and investors when selling real estate. For primary residences, the IRS allows homeowners to exclude up to $250,000 of capital gains if filing as a single taxpayer, or $500,000 for married couples filing jointly. To qualify, the property must have been the taxpayer’s primary residence for at least two of the previous five years.

Investors can reduce capital gains taxes by utilizing long-term capital gains rates, which range from 0% to 20%, depending on taxable income. Offsetting gains with capital losses, known as tax-loss harvesting, is another strategy to minimize taxes. Accurate records of home improvements are essential, as these costs can increase a property’s basis and reduce taxable gains. Consulting a tax professional is recommended to ensure compliance and optimize tax strategies.

Passive Activity Losses

Passive activity losses (PALs) are particularly relevant for rental property owners. Under IRS rules, losses from rental properties are generally classified as passive and can only offset passive income. However, exceptions exist for real estate professionals and certain income thresholds.

Real estate professionals who materially participate in rental activities can treat rental losses as non-passive, allowing them to offset active income. To qualify, individuals must spend over 750 hours annually on real estate activities and derive more than half of their personal services income from these activities.

For non-professionals, taxpayers with an adjusted gross income (AGI) of $100,000 or less may deduct up to $25,000 in passive losses against non-passive income. This allowance phases out between $100,000 and $150,000 of AGI. Proper documentation of expenses, including repairs, maintenance, and depreciation, is necessary to substantiate losses and avoid disputes during audits.