Too many doctors rely purely on W-2 income, and the harder you work and the more patients you take on, the higher your taxes end up being. For physicians and similar busy professionals, real estate investing can be a low-maintenance, low-effort form of earning additional cashflow with a potentially much lower tax rate, freeing you up to take on a little less work and enjoy more free time with family and friends.
Real estate investing isn't just able to offer reliability and secondary sources of income; it can also offer a range of tax benefits too.
Almost everyone wants to pay fewer taxes since they make up one of our biggest annual expenses for healthcare professionals. Investing in real estate can help with this in a variety of ways, including depreciation, appreciation, capital gains, and live-in flips. Before you decide to go down the rabbit hole of real estate investing, let’s discuss the tax benefits of investing in real estate.
One of the most important things for any newbie real estate investor to learn is the importance of depreciation.
In simple terms, the IRS acknowledges that assets will lose value over time, offering depreciation tax deductions to real estate owners. In general, depreciation on an investment property lasts for 27.5 years on residential properties and 39 years on commercial properties, allowing you to deduct a defined amount from your taxes each year of the asset’s life.
A huge advantage of investing in real estate is the potential for appreciation.
It's a simple and proven fact that, in general, property prices tend to go up. As populations have increased over the years, demand for properties has increased and the price of homes has similarly risen. You don't have to pay any tax at all on appreciation while you own the property - you can buy a property, hold onto it for many years, let the value grow, and then pay any tax on the gain of the investment (hopefully in a year with a lower taxable income).
All rental profit and capital gains earned through your property investments is not subject to FICA (aka Social Security and Medicare) taxes.
Usually, you'll pay 7.65% of your salary in FICA taxes, or 15.3% if you happen to be self-employed. This can work out to be quite a lot of money, depending on your income, but with rental income, the FICA rate is zero.
A great way to enjoy a huge and immediate reduction in your taxes is to purchase a property and then move in straight away, making it your primary residence, known as a “live in flip.”
You can benefit from a whopping $250,000 tax break as a single person or $500,000 as a couple on any gains realized on the sale of the property, as long as you live in the home for 2 years of a 5 year period. Many investors from the healthcare field have made the most of this strategy, moving from one property to the next and benefiting from subsequent tax breaks again and again.
Capital gains represent one of the most important benefits in regard to real estate.
Essentially, 'capital gains' refers to the profit you make by selling off an asset (like a property) for more than you originally paid, and you're usually taxed on those gains via a capital gains tax. For short-term investments, the capital gains tax rate is similar to the rate for all other earned income (up to around 37%). However, if you hold onto a property for just a year and a day, the capital gains tax rate drops right down, as low as 0 to 20%. Busy healthcare professionals can, therefore, invest in a property and simply hold onto it, waiting for the capital gains rate to reduce.
Named in honor of Section 1031 of the Internal Revenue Code, a Sec. 1031 exchange is a popular tactic with many serious property investors to reduce their taxes.
Basically, it lets you defer taxes by selling a property and then using the capital gained to make a purchase of another (or multiple, depending on the amount of equity) properties.
There are certain rules and regulations around this. For example, you only get a set period of time to make the investments and the properties involved need to match up with certain criteria, but as long as you read the rules and follow them correctly, you can vastly reduce your taxes from one year to the next.
As an example, let's say you're selling a property at about $200,000. Without the 1031 exchange, you'd have to pay around $20,000 or more in taxes for capital gain. However, with the 1031 exchange, you get to keep that $20,000, invest in a new property, and then watch it grow over the life of the new asset. This can continue to be done multiple times but excellent record keeping is a must to track the reinvested gain from property to property.
By taking advantage of installment sales, you can cut your tax rates on all property sales.
They allow you to defer the payment of capital gains tax, but you will still need to pay depreciation recapture at the moment of sale. In practice, installment sales involve the seller receiving their payment for the sale over a period of time, rather than all at once. It's basically like giving a buyer a line of credit, and you only have to pay taxes on the principal and interest received annually, rather than the full lump sum of the sale.
When looking to build up their capital, a lot of property investors will simply sell off some of their properties. This is a quick and obvious way of raising money, but it comes with some risks, and there's a simple, alternative method available to you in the form of refinancing.
Refinancing allows you to essentially draw tax-free capital out of your investments without even needing to sell them.
You won't have to pay any tax on the borrowed money but you will have to pay interest. There are some risks associated with this, and you need to choose your property carefully, opting for a strong and dependable piece of real estate that you feel confident in, but with the right choices or professional advice on your side, this method can really pay off in a big way.
An IRA or even a 401k can be a great way to invest in property and minimize your taxes paid.
Many people, including busy physicians and doctors, make the mistake of thinking that IRAs and 401ks are only for investing in stocks and bonds, but when set-up properly, you can invest in properties too. There are even specialized companies that can help you make investments in property and other 'non-traditional' assets through your IRA.
The ultimate key is to take your time, do the necessary research, and weigh up your options carefully. Real estate investment isn't something that anyone should simply be diving into headfirst. It requires patience, planning, and care, but with the right approach, the sky's the limit for real estate investors looking to cut down on their taxes, as we can see from the many benefits listed above.
Have you started investing in real estate and seen tax benefits to your personal tax situation? Please share your experience!