There are five fundamental ways that owning investment real estate can reduce your income taxes.
1. Depreciation deductions each year allow you to write off part of the cost of your investment, which results in lower taxable income and lower taxes. If you have a $1,000 tax deduction, $1,000 of your income will be tax-free. This is called sheltering. Tax shelters are not just for the rich.
2. Virtually all expenses associated with owning and operating investment properties, including mortgage interest, are deductible.
3. Some real estate investments give you tax credits. Tax credits are used to reduce your tax liability. Dollar for dollar, these are more valuable than deductions. If you are in the 28% tax bracket, then a $1,000 tax credit means that $3,571.43 of your income will be tax-free (28% of $3,571.43 is $1,000). You would have to pay $1,000 in taxes on $3,571.43, but the tax credit wipes out your tax liability.
4. With capital gains tax rates, you can sell real estate after owning it for one year and pay taxes at a greatly reduced rate. Right now, the highest tax rate for an individual’s ordinary income (wages, salary, rents from property, interest, dividends, etc.) is 35%. The highest capital gains tax rate is only 15%. Flippers usually cannot take advantage of capital gains tax rates. This is discussed more later.
5. Under certain circumstances, you can sell investment real estate, buy another property in a fairly short amount of time, and pay no income taxes on your profit! This is called a 1031 (ten–thirty-one) exchange and is discussed in more detail later.