Depreciation is a non-cash expense that allows you to deduct a portion of the cost of your property each year, thus lowering your taxable income. This is based on the concept that assets like buildings lose value over time due to factors like wear and tear.
Depreciation starts when you place the property in service for rental use and continues each year until you’ve deducted your entire cost basis or until you stop using it as a rental. Land is not depreciable, so you will need to determine the value of the building apart from the land to calculate your depreciation deduction.
A 1031 exchange, named after section 1031 of the IRS code, allows you to swap one investment property for another without immediately incurring a capital gains tax. It essentially means you can change the form of your investment without cashing out or recognizing a capital gain, thereby allowing your investment to grow tax deferred.
There are specific rules and timeframes to adhere to when conducting a 1031 exchange, including a 45-day window to identify potential replacement properties and a total of 180 days to complete the purchase of the new property.
Understanding the distinction between short-term and long-term capital gains tax is crucial for real estate investors. Properties held for less than a year before being sold are subject to short-term capital gains tax, which is generally the same rate as your ordinary income tax.
On the other hand, properties held for more than a year qualify for long-term capital gains tax, which has significantly lower rates. This can provide a substantial tax advantage for investors willing to hold onto their properties.
Achieving real estate professional status can have significant tax benefits. It allows you to deduct all real estate losses against your other income, without being limited by passive loss rules. However, qualifying for this status requires substantial time investment, typically more than half of your total working hours and more than 750 hours per year.