12 Tax Strategies for Real Estate Investors in 2023

Real estate investment can lead to significant short-term and long-term financial returns, adding an additional income stream and diversifying your portfolio risk. However, you could be hit with significant capital gains taxes when you sell properties. The good news is that several tax incentives are designed to support investors like you. From the 1031 exchange to tax credits, learn the best tax strategies for real estate investors to save more while building your portfolio.  

1031 Exchange

The 1031 exchange, named for its appearance under Section 1031 of the United States Internal Revenue Code, is one of the most popular real estate investing tax strategies. The 1031 exchange is the ability to defer recognition of capital gains by exchanging certain types of comparable property. This strategy allows investors to defer capital gains taxes by reinvesting the proceeds from the sale of one property into the purchase of another like-kind property.

For example, you can sell a building with four apartments and purchase a 10-apartment building without paying capital gains taxes. The 1031 exchange is typically used by real estate investors to purchase progressively larger properties.   

Depreciation

Residential and commercial properties can be depreciated over a specific period, providing investors with a tax deduction that accounts for the property's wear and tear. 

Rather than taking one large deduction in the year that you buy or improve the property, depreciation distributes the deduction across the useful life of the property. According to the Modified Accelerated Cost Recovery System (MACRS), depreciation spreads costs and depreciation deductions over 27.5 or 30 years, depending on the method used.

Several factors determine the amount of depreciation you can take and the possibility for accelerated depreciation deductions. Speak with a CPA to understand your situation's maximum depreciation and accelerated timelines. 

Deductions for Rental Properties

Investors can deduct various operating and maintenance expenses related to their rental properties, such as mortgage interest, property taxes, insurance, maintenance, repairs and property management fees. To take advantage of expense deductions, keeping detailed records and receipts for expenses is essential. 

Passive Activity Losses

Real estate investors can offset passive income with passive losses from their real estate activities, reducing their overall taxable income. With passive losses, you can deduct depreciation and other expenses from income. 

For example, if you own a rental property and net a rental income of $4,000, but the depreciation deduction is $6,000, there would be a passive loss of $2,000 for tax purposes. Assuming no other expenses, the investor would make $4,000 in net income.

Real Estate Professional Status

If an investor qualifies as a real estate professional by meeting certain criteria for time spent and material participation, they can deduct rental losses from their non-passive income, leading to additional tax savings.

Cost Segregation

Commercial property owners can allocate the cost of their property to various components with shorter depreciation schedules, resulting in accelerated depreciation and larger upfront deductions. For example, you can depreciate certain elements like the plumbing or electrical fixtures on a shorter timeline. 

To take advantage of cost segregation, you'll have to pay for a cost segregation study, which can cost between $5,000 to $15,000, although some online listings suggest private cost segregation studies for as little as $400. 

Home Office Deduction

Real estate professionals who conduct business from a home office, for example managing rental properties, may be eligible for deductions related to the home office's expenses. To qualify, you must have a dedicated space, calculate the percentage of your total property used, and cannot use the home office for any other purposes. While this is small compared to other deductions of this list, every little bit counts.

1031 Reverse Exchange

A 1031 reverse exchange is like a regular 1031 exchange, except the replacement property is acquired before the relinquished property is sold. This method is helpful for investors who find an excellent market opportunity, secure the purchase, and then relinquish the other property. 

With a 1031 reverse exchange, you have a total of 180 days to complete the transaction. First, you have 45 calendar days to identify what you will sell as your relinquished property, and you have an additional 135 calendar days to sell the property and close out your reverse 1031 exchange.

Qualified Opportunity Zones

Investing in designated opportunity zones can provide tax benefits, including deferral and reduction of capital gains taxes if certain criteria are met. The U.S. Department of Treasury notes that you can use the Census Bureau's online geocoder tool to find qualified opportunity zones. With that, you can check the census tract of a specific address. From that, you can use the Opportunity Zone mapping system or the list of designated Qualified Opportunity Zones to determine the status of that census tract. 

Self-Directed IRA/401(k)

Investors can use self-directed individual retirement accounts (SDIRAs) to invest in real estate, potentially deferring taxes until retirement. You can also consider a Roth IRA or traditional IRA to invest in REITs with tax-advantaged savings. 

With an SDIRA, you can invest in different assets, such as properties. A self-directed IRA is held by a custodian. You may need to create an LLC or other legal entity to buy and own investment properties and hire a custodian or trust company to administer the self-directed IRA.  These unique IRAs allow you to invest money into properties with significant tax advantages.  

Real Estate Investment Trusts (REITs)

Investing in REITs provides access to real estate income and offers tax advantages because of their special tax treatment. Investing in REITs through a Roth IRA or 401(k) can offer additional tax savings. 

Tax Credits for Energy-Efficient Improvements

Some energy-efficient improvements made to properties can qualify for tax credits, usually only on your first rental property. However, you might need to use the property as a second home for some time to qualify. 

Possible expenses for energy-efficient improvement credits include:

• Exterior doors, windows, skylights and insulation materials
• Central air conditioners, water heaters, furnaces, boilers and heat pumps
• Biomass stoves and boilers
• Home energy audits

You might also qualify for the Residential Clean Energy Credit for the installation of:

• Solar, wind and geothermal power generation
• Solar water heaters
• Fuel cells
• Battery storage 

Using Tax Strategies for Real Estate Investors

Real estate tax strategies can help you save thousands of dollars on annual taxes. Remember that everything adds up, from expense deductions to depreciation deductions. By including tax planning, real estate investments can mean additional portfolio growth and asset value. A tax professional can help you understand which of these opportunities you can apply to optimize returns and save more for further investment growth this year. 

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