While I dutifully recorded my own tax deductions this year, it put me in a list making mood. Here's a list of some of the tax benefits of owning investment property.
• Depreciation
Depreciation is a deduction available to real estate investors. It allows you to deduct the cost of assets such as buildings and substantial improvements to buildings over a period of time defined by the IRS. The cost of a building can be depreciated over a period of 27.5 years. This is done by dividing the cost by 27.5 and then subtracting the resulting quotient from the property's income each of 27.5 years. If the cash flow on a property is just above the property's carrying costs, this would result in your making an actual profit but not paying any tax.
• Expense Deductions
Just about every expense associated with rental property is deductible. Mortgage interest, real estate tax, maintenance, property management, even your transportation costs to visit the property are all expenses, fully deductible in the tax year they are incurred.
• Capital Gains
When you sell a rental property, the profits are taxed as capital gains as opposed to ordinary income. The difference is important, because the maximum capital gains rate is 15 percent, whereas the maximum tax rate on ordinary income, as of 2010, is 35 percent.
• 1031 Exchange
If you plan to sell your rental property and buy a larger one, there is only one smart way to do it: through a 1031 exchange, also called a deferred exchange. In this process an exchange facilitator takes the cash that comes out of your sale and holds it until you close escrow on a replacement property. You must identify that property within 45 days and close within six months. It must be purchased for more than the price for which you sold your first property. If you keep using exchanges to sell and then buy, you defer the tax due forever.
• Tax-Free Cash-Out
When you sell without doing a 1031 exchange you pay taxes on the profit; when you take cash out through a refinance, the money is tax-free until you sell. If you never sell, you never pay taxes. This is an excellent tax strategy for retirement: once you pay off or pay down the mortgage on a rental property you can refinance it and take cash out and still have the monthly rents coming in.
