Tax Breaks for Buy-and-Hold Investors: Part 2
November 24, 2017
In Part 1 of our Tax Breaks for Buy-and-Hold investors, we covered an overview of deductions for real estate investors as well as the advantage of long term capital gains. Continuing with our series on the advantages of buy-and-hold investing, below we'll discuss self-employment taxes, appreciation, and the benefits of tax-free refinancing. Let's dig in!
4. Self-Employment Taxes
"Wait, are you saying the IRS taxes me extra for being self-employed?" Well, kind of.
FICA, the Federal Insurance Contributions Act (aka Social Security and Medicare) is typically shared by the employee and employer 50/50, or 7.65% each.
Self-employed filers, however, are usually not exempt from FICA; even worse, they typically must cover the entire 15.3% tax! Thankfully, this is where one of the best perks of investing in long-term real estate kicks in: unlike ordinary self-employment income, rental income is exempt from FICA! That means enormous savings for investors supplementing (or living) off of rental income.
There is one disclaimer to this rule, however: depending on the structure of your business, not all real estate investors may get to enjoy the full exemption. For example, landlords who pay themselves a property management fee will likely pay self-employment taxes on this amount, as it is considered "earned income" rather than rental income. Similar issues may be encountered by incorporated businesses. While structuring your business for optimal tax treatment is a vital aspect of real estate investment, this topic will be explored in a later post.
One of the nice things about real estate is that, in general, property value increase over time. Even in more competitive markets, the discerning investor can take advantage of this by acquiring discounted properties due to neglect, foreclosure, or outdated upkeep. With time, the natural increase in property value means 1. better rental income opportunities, and 2. more equity to leverage for future purchases (see #6 below).
While this would ordinarily result in an accordingly higher tax upon sale of the property, some investors (Warren Buffett comes to mind) simply refrain from sale of the property. For buy-and-hold investors, this means growing rental income opportunities and equity for business growth with virtually zero tax consequences. Which brings us to:
6. Tax-Free Refinancing
Many investors must use financing to acquire their investment properties, particularly in the early stages of investment. While the usefulness of this tool is limited in those cases, for investors with a large amount of "equity" in their property (that is, property value not encumbered by a mortgage or other loan), a stellar opportunity for putting tax-free cash in your pocket presents itself. Say, for example, you purchase a property worth $300,000, with 20% down ($60,000) and the remainder financed through a traditional mortgage ($240,000). Several years later, you've paid the mortgage down to $100,000, leaving the remainder ($200,000) the equity in your purchase. Now, some investors may choose to enjoy the reduced mortgage payments and pocket the extra rent-- growth-oriented investors, however, may wish to "refinance" and put the extra cash towards another purchase, renovation, or miscellaneous expense. In the above example, say you decide to use the equity in your property to take out a new mortgage for $150,000, and pay off the old mortgage ($100,000). After you're left with $50,000 cash in hand, tax free, and still enjoy another $150,000 in remaining equity in your property for future use. This is how many investors grow their businesses-- by taking out tax-free equity from properties through refinancing, you now have the funds for another purchase.
And so ends part 2 of our guide to tax breaks for buy-and-hold investors. While short-term sale of properties is certainly an excellent investment opportunity in itself, we've also seen how the IRS favors long-term investment in properties. If you have more questions about maximizing the tax efficiency of your investments, contact us at JSB Tax Services.