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Taxation of Real Estate Investments

By Paul J. Carroll, CFP®March 16, 2023Videos


If you’re a real estate investor, of course one of the big bugaboos is real estate taxation – how do you maximize the tax benefit of your real estate investment?

To an extent, almost all of us are real estate investors, even if we’re not thinking about it. As a homeowner you’re enjoying a mortgage interest deduction, probably, and a property tax deduction. There are limits, a $10,000 cap here, a million dollar mortgage there. But in essence, even a homeowner is getting some kind of tax break. And should you sell that house between $250,000 and $500,000 in capital gain can get rolled into a future house. All good reasons if you’re staying put, to consider real estate for your residence because it’s also an equity building tool.

However real estate investors, in addition to these breaks, can depreciate the property and enjoy other much more sophisticated benefits. Depreciation is the magic word here. When you own a building, you can depreciate that building over 27 and a half years if it’s residential, or 39 years if it’s commercial. That’s a straight deduction off the income from your property. Now there are passive activity rules, I’m not going to get into those. In essence, passive activity rules determine if you’re a professional investor or is this a passive investment that you’re doing on the side? And it effects can you write off these costs against your real estate investment or other ordinary income? For these conversations, we’re going to assume these are passive activities.

The interior of a building, anything that’s non-structural, can actually be depreciated over five, seven or 15 years using modified accelerate cost reduction schedules. To figure out how to maximize depreciation, there’s something called a cost segregation study. At Avion we work with a number of professional partners that can run cost seg studies. Cost seg studies make the most sense for larger commercial investments, warehouse properties, factories, plants, retail space, things like that. So, depreciation’s a great advantage. Being able to take depreciation against your earnings reduces the tax footprint of the investment. But there’s a gotcha hidden in it, and it’s called depreciation recapture. A lot of people do not understand that when you depreciate a property that you actually will sell for more, you are not getting a tax break, you’re really getting a tax deferral, and you have to pay those gains back.

What happens is that depreciation accumulates. When you sell a property at a gain, the IRS says, “well then it’s not depreciated, is it? We want to recapture that depreciation and tax you at 25%.” So we can see an upper charge opportunity. If you’re in the 37% tax bracket, you’re like, “okay, it’s not perfect, but it’s not bad”. If you’re in a 15% tax bracket, that can actually mean you’re having a negative long-term impact. Additionally, you have capital gains on any subsequent gain in the value of the property. Capital gains are 20%, but you also get Medicare tax and some other things depending on the situation.

So, the trick with real estate is to maximize the tax advantage. How do we defer those gains, ideally until you pass away? There are other strategies to literally wipe those gains out. We’ll talk about those in future posts.

We wish you the best of investment and real estate investment success.



Paul J Carroll
Founder & CEO at Avion Wealth

Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.