By Dr. James M. Dahle, WCI Founder
Everyone is always talking about the “tax advantages of real estate,” but few can really articulate them well. Many get confused about how they work, and others cite tax advantages that have nothing to do with real estate (“You can deduct your expenses!”). This post will actually list out the tax advantages of real estate, but before we do so, let's talk about the four biggest tax disadvantages of real estate.
Tax Disadvantages of Real Estate Investing
You weren't expecting this section when you clicked on the post, were you? Yes, real estate has tax disadvantages. Let's talk about them.
#1 Real Estate Income Is Subject to Ordinary Income Tax Rates
Income that you get from real estate is subject to ordinary income tax rates. It doesn't qualify for the lower qualified dividend rates that most stock dividends receive. While equity real estate income (rents) can be offset by depreciation, once that's gone, you're paying taxes on rents at your ordinary income tax rates. On the debt side (i.e. loaning money to real estate developers, mortgages, etc.), your entire return is income that is fully taxable at your marginal ordinary income tax rates every year. It is the most tax-inefficient asset class in my portfolio. This is very different from stocks, stock mutual funds, cryptoassets, and even collectibles. Not only is the income subject to higher tax rates, but there is generally more of it. Less of the return comes from easily deferred capital gains.
#2 Difficult to Use Losses Against Earned Income
People lose money in real estate all the time, and then they find out that they can't use those losses for anything. Realized capital losses from stocks and mutual funds can be used against earned income, even if only $3,000 per year. That's not the case for real estate. Real estate losses can only be used against earned income in some special circumstances (see #10 below) Obviously, capital losses can be used against capital gains and real estate losses can be used against real estate income but not easily against earned income—especially for high earners.
#3 Difficult to Protect with Retirement Accounts
Perhaps the greatest tax gift to investors is the ability to invest in tax-protected accounts. However, it can be very difficult to invest in real estate in these accounts. Most IRAs, 401(k)s, and HSAs are set up for mutual funds. Sometimes, the plan offers a publicly traded REIT mutual fund, but it often doesn't. Forget about investing in private real estate unless you want to deal with the extra cost and hassle of a self-directed IRA or solo 401(k). Even when you do go through that hassle with a self-directed IRA (but not a 401(k)), expect to pay an extra tax if you have leveraged equity real estate in there, the Unrelated Business Income Tax (UBIT). Certainly, you should not plan on using property yourself that has been put into an IRA. Without retirement accounts, you lose lots of tax and asset protection, and this often forces investors to choose between the benefits of using retirement accounts and investing in real estate.
#4 Difficult to Tax-Loss Harvest
Even in a taxable account, mutual funds have advantages over real estate. They're easy to tax-loss harvest. Plenty of similar but not “substantially identical” options exist, and transaction costs are nearly zero. That's not the case with any sort of private real estate.
More information here:
Tax Advantages of Real Estate Investing
Now that we have the disadvantages out of the way, let's talk about the advantages. There are many, some more useful than others. The manner in which you invest in real estate will determine for which of these tax breaks you qualify. People invest in real estate all across what I call the Real Estate Continuum.
Some tax breaks are available on the left side but not the right side and vice versa.
#1 Generous Depreciation Laws
Perhaps the most significant tax break in real estate is the ability to use depreciation as an expense. Now, depreciation is real. Houses and buildings really do wear out and need to be replaced. However, the depreciation laws are, frankly, way too generous. You're allowed to depreciate improvements far more rapidly than they are actually wearing out. Reasonably maintained houses simply aren't worthless after 27 1/2 years, and most commercial buildings don't fall apart after 39 years. Thus, a portion of the depreciation deduction is unfairly generous and is, in reality, just a paper loss shielding real income from taxation. It gets even better (worse?) when special bonus depreciation laws are put into place from time to time. Cost segregation studies can allow a property to be split into pieces where some of it is eligible for even faster depreciation. Mutual funds can't pass through capital losses to you when the manager sells stocks at a loss, but they will pass through gains even if the overall return is negative. A property or partnership investing in real estate will pass through depreciation losses for you to use against real estate income from other real estate investments.
#2 Depreciation Recaptured at a Maximum of 25%
You know what else is “unfair” to the advantage of real estate investors? When depreciation is recaptured, it isn't recaptured at the same tax rate at which you initially took the deduction. It is only recaptured at a maximum rate of 25%. If you took the deduction at 37% and then repaid it at 25%, that's a winning move similar to what happens with most doctors' tax-deferred retirement account withdrawals in retirement.
#3 1031 Exchanges
When you sell a mutual fund and buy another, you must pay capital gains taxes. That's not the case with real estate investments. If you follow the rules for a 1031 exchange, you can swap from one property to another without paying taxes until you sell the new property. While the basis/depreciation taken carries over to the new property, you can still restart the depreciation process if you're swapping into more expensive properties. If you combine 1031 exchanges, depreciation, and the step up in basis at death (which is available with all investments), you can invest extremely tax-efficiently in direct real estate with this formula . . .
. . . and nobody will ever pay depreciation recapture taxes or capital gains on any of that income or appreciation.
#4 Return of Principal Distributions
Some real estate investments, both public and private, are set up as Real Estate Investment Trusts (REITs). Mutual fund investors generally consider these to be fairly tax-inefficient investments. They're mostly suitable to be in tax-protected accounts like IRAs, 401(k)s, and HSAs because they kick off more income than most stocks and because that income is mostly ordinary dividends, not qualified dividends. However, REITS do have two tax advantages. The first is that some of their income may be a “return of principal” distribution. This is essentially how the REIT passes depreciation through to its investors. Obviously, that depreciation can't be used against income from other real estate investments, but it does help shield income from this investment.
#5 199A Deduction
The other REIT-specific tax advantage is the 199A deduction. In place from 2018-2025, this law designed to level the playing field between corporations and pass-thru entities, like sole proprietorships and S Corps, gives special treatment to REIT dividends. Basically, 20% of a 199A dividend is not taxable. This essentially lowers the tax rate on REIT income from a maximum of 37% to 29.6%. Not huge, but better than a kick in the teeth. REITs should still be one of the last asset classes moved out of retirement accounts into a taxable account.
#6 721 UpREIT Exchanges
Another unique REIT-related tax break is an exchange where you can take an appreciated property and exchange it into a REIT. You end up with REIT shares, but you don't pay taxes on that appreciation until you sell those REIT shares. This one can be tricky, because you have to find a REIT that wants that individual property. But there are situations where it could work out.
#7 Opportunity Zone Funds
Speaking of ways to defer and minimize taxes on appreciated investments (not just real estate investments), you can take money from any investment you sell and invest into a real estate “Opportunity Zone” (OZ) fund and enjoy a few tax benefits including:
- Deferring capital gains taxes through 2026
- Step up in basis of 10% (five-year hold) to 15% (seven-year hold) of deferred gain (note that this required you to invest by 2021 and 2019, respectively, to get this benefit)
- No tax on appreciation if you stay invested in the fund for at least 10 years
#8 Capital Gain Exemption on Personal Residence
If you have lived in a property for two of the last five years, you can sell the property and not pay capital gains taxes on up to $250,000 ($500,000 married) in appreciation. Savvy investors can move out of their residence and rent it for a few years or move into a rental and live there for a few years, and they'll save some taxes due to this exemption.
#9 Self-Rental (Augusta Rule)
Per Section 280A of the tax code, you can rent your personal property to your business (or anyone else) for up to 14 days a year at market value and not pay any tax on the income. As long as it is a legitimate business expense, your business can take that payment as a deduction. Voila, tax-free business/rental income.
#10 Qualify to Use Passive Losses Against Earned Income
While it can be difficult for most practicing doctors to use passive real estate losses (ideally just the “paper loss” of depreciation) against earned income, it is possible. While beyond the scope of this article, there are a number of ways to qualify including:
- Real Estate Professional Status (REPS): Working 750+ hours in real estate and no more than that in any other profession.
- Short-Term Rental Loophole: If you're managing your own short-term rental properties, you do not need to hit 750 hours to use losses against regular income.
- Not High Income: If your Modified Adjusted Gross Income (MAGI) is < $100,000, you can deduct up to $25,000 in passive losses against ordinary income.
- Short-Term Rental Combined with Significant Personal Services: Make it more than just a rental business, and those losses can be used.
- Extraordinary Personal Services and Rental Activity Only Incidental or Insubstantial: Especially if the rental is a trivial part of the business.
- Disposition of the Passive Activity: When you sell the property, it unlocks those passive losses and allows them to be used against active income.
As you can see, there are numerous tax breaks associated with real estate investing. Understand which ones you qualify for and take advantage of them.
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What do you think? What real estate tax deductions have you used? Which do you hope to use in the future? Comment below!