As you build your real estate investment portfolio, secure a property management company to assist you, and rent your properties out, your investment will begin to pay off in the form of passive rental income. This is an excellent way to build wealth — whether you’re using it to supplement your regular income or are using real estate investments to fund your retirement.
When the taxman comes calling, it can really hurt when he takes a large chunk of your hard-earned money. One of the attractive things about real estate investing, however, is that there are ways to insulate yourself and take advantage of tax breaks available to investment property owners. As tax time comes around again, here’s how to protect your investment income to the fullest extent.
How to Protect Your Investment Income
Understand Your Deductions
Paying your taxes is as American as apple pie, but so is taking every deduction the tax code allows. When you run your own business, there are plenty of items that can be deducted as business expenses. This is also the case if you rent out investment properties. As a landlord, you’re able to deduct your current expenses, as well as your capital expenses.
Understanding which items qualify as expenses is the first step in learning how to protect your investment income. Current expenses are one-time items that help you run your business or keep the property in good working order. They must be written off in the same year they occur.
In order to be considered a current expense, an item must be:
- Ordinary and necessary: It must be something that is typically accepted as standard in terms of running an investment rental business. Maintenance, utilities, insurance, taxes, interest, and advertising would be considered “ordinary and necessary.”
- Short-Term: In order to be considered “current,” the item must be more valuable in the short-term than in the long-term. This would apply to making repairs, for example, but not replacing large items or conducting a renovation.
- Business-related: The expenses must be directly related to your rental property business.
- Reasonable: Any unusually high amounts will raise red flags with the IRS.
You can also deduct any capital expenses. These are items or actions that increase the value of the property in some way. While repairing a broken pipe in the kitchen is a current expense, gutting and remodeling the entire kitchen to update the property is a capital expense. Because capital expenses are expected to generate revenue for future years, they are capitalized and depreciated over several years.
Know How to Structure the Business
When researching how to protect your investment income, you’ll also find that the way you structure your business matters in terms of tax deductions. Many people opt to form an LLC and place ownership of a property there rather than owning it personally. This offers protection of your personal assets should any sort of accident occur on the property that results in a lawsuit, for one, but it also gives you access to tax benefits that wouldn’t be available otherwise.
Because an LLC is a pass-through organization, any income generated by these kinds of entities is eligible for the new tax breaks laid out by Congress in 2017. This includes the ability to deduct 20 percent of your business income, as well as a drop in the tax rate from 37 percent down to 29.6 percent on all taxable income.
Putting your investments to work for you to generate cash flow is a wonderful thing. It’s even better when you take the time to learn how to protect your investment income. When you do that, you’re able to maximize every single dollar.
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