Real estate investors and owners often have multiple ways to complete a taxable transaction. Most of the time, they do tax planning to evaluate different tax options and determine how to conduct transactions to reduce or eliminate their tax liabilities.
This shrewd planning of structuring transactions to reap the largest tax benefits is called “tax avoidance.” It’s extremely wise, completely legal, and radically different from the criminal act of “tax evasion.”
Understanding Tax Avoidance
Tax avoidance is a legal and legitimate method many taxpayers can use to minimize tax bills or even avoid paying taxes. It can be accomplished through various credits, exclusions, deductions, and loopholes, including:
In the United States, many individuals and businesses use tax avoidance to cut down their tax liabilities to the Internal Revenue Service (IRS) legitimately and legally. This is why it’s also considered a “tax shelter.”
How Legitimate and Legal Tax Avoidance in the US?
Many government bodies heavily evaluate, monitor, and regulate all tax avoidance strategies. They were initially approved by the US Congress. That means they all passed through and signed by the US President before becoming parts of the US Tax Code.
Once they become provisions for offering relief to all taxpayers in the state, they’re built into and monitored by the Internal Revenue Code (IRC). They use the Tax Code to assess which citizen will be given these provisions, including tax credits, deductions, or exemptions.
Employing the Tax Code enables lawmakers to manipulate citizen behaviors to indirectly subsidize specific essential services, such as higher education, retirement savings, and health insurance. It’ll also help them achieve national goals like greater energy efficiency.
When Does Tax Avoidance Become Illegal Tax Evasion?
Tax evasion is an illegal way to reduce tax liabilities, typically by deceit or concealment. That means engaging in it is a crime. Often, the distinction between it and tax avoidance turns upon whether the strategies taken by a taxpayer are with fraudulent intent.
For example, in the US, here are common ways to evade tax in real estate:
These are only a few ways real estate owners can commit tax evasion. In fact, most businesses are subject to more scrutiny because they have more options to avoid tax liabilities, both legally and illegally, compared to wage-earners with a similar income level.
What Are the Tax Avoidance Strategies Real Estate Investors Can Use?
The good news is that investment properties have more tax advantages than other typical side hustles. Real estate investment is a perfect way to generate valuable, recurring cash flow from a mostly passive income while enjoying an incredible number of tax benefits.
Here are some of the tax avoidance strategies every real estate investor must know:
1. Tax Advantage of Real Estate Tax Write-Offs
This income stream comes with real estate investment tax deductions. These are directly tied to the property’s operation, maintenance, and management. Some examples of deductions are:
All of these deductions can reduce taxable income. However, ensure to keep detailed, accurate records and receipts that can prove these expenses. Doing so is very critical when audited by the IRS. Without evidence, you’ll be likely subject to tax evasion.
2. Own Properties in A Self-Directed IRA
Individual retirement accounts (IRAs) and Roth IRAs are known as tax-deferred ways to invest for retirement. What’s unknown to many is that they can also be used to invest in real estate “tax-free.” These are called self-directed IRAs.
The catch is that a self-directed IRA is as complicated as processing either the traditional or special account Roth IRAs, probably even more complex. That’s why a custodian or trust company is a must to administer it.
Before committing to a custodian, ensure that you’ve done your part. Do your homework and understand the process of a self-directed IRA, ideally “fully.” If not, ask the custodian or a trust company about the entire process and all fees.
3. Hold Properties for More Than One Year
Selling a property after less than a year of owning it taxes its profits at a normal income tax rate. However, if you sell it after a year of holding it, it can be sold at a capital gains tax rate, typically at 15% or around a standard rate.
Even better, sell the property after over a year of holding it. This is more profitable because the property’s value has already been appreciated. Not only that, you can enjoy several tax benefits.
For example, if you stay in the property for at least two years, the first $250,000 of capital gains is tax-free for unmarried. For married individuals, a total of $500,000 is the limit. Consider these first two years a home improvement period and an excellent way to earn tax-free money.
4. Take Advantage of A 1031 Exchange
Section 1031 Exchange of Tax Code, otherwise known as a “like-kind exchange,” allows real estate investors and owners to defer paying taxes “indefinitely” by purchasing another property similar or closely similar to their previous ones with their proceeds. Conversely, if property investors and owners classify their profits as income, they’ll pay capital gains taxes or taxes on the profits.
While reinvesting with 1031 exchanges is a sound approach, navigating and taking full advantage of it can be complicated. It has different forms depending on property purchase and sale transaction timing. As such, it’s wise to consult with a qualified financial professional.
5. Defer Taxes with TCJA Incentive Programs
Besides the 1031 exchanges program, opportunity zones are another major real estate tax benefit. By definition, “opportunity zones” are disadvantaged, more specifically, “low-income” tracts of land designated by the US Department of Treasury.
Under the Tax Cuts and Jobs Act of 2017 (TCJA), property investors can get tax breaks if they invest in developing and economically stimulating opportunity zones. Like other real estate investments, unrealized capital gains will be placed into a Qualified Opportunity Fund. Money from this fund goes toward developing selected opportunity zones.
Overall, this program enables investors to enjoy the following tax benefits:
Opportunity Zones are just among the tax minimization strategies designed by the TCJA to incentivize property investors. In recent years, they also designed the “20% pass-through deduction.”
Under pass-through deductions, business owners can get an extra 20% deduction of their net business income. For real estate investors, this means getting a full 20% deduction of their real estate business income can be deducted from their taxable income.
Contrary to what most people think, tax avoidance is legitimate and legal. There are different strategies in place to administer it, but generally, they minimize taxable income, maximize tax deductions and tax credits, and control the timing of income and deductions. Regardless of these, skillful and effective tax planning is necessary to reap tax avoidance benefits fully.