If you’re a high-income individual, it’s no surprise that you’re taxed at higher rates for your ordinary income. By investing in real estate alongside proactive tax planning, you can help reduce your tax burden while increasing your total income.
If you’re interested in real estate investing, both the long-term and short-term rental markets are key investment opportunities that offer tax savings. By taking advantage of tax strategies vis-à-vis real estate investment properties — both long- and short-term rentals — you may generate huge tax savings while also increasing profits from your investments.
Key Takeaways
- Your real estate investment portfolio may include several different types of properties. Commonly, investors own properties rented out to tenants on a long-term and/or short-term basis. Though the same general passive loss rules apply to both long- and short-term rentals, the IRS has a slightly different treatment for the two investment classes which may result significantly different tax results.
- While the IRS requires long-term rental investors to meet “real estate professional” status to obtain certain tax benefits, the more lenient “material participation” rule applies to short-term rental investors. This means that for people who are high W-2 earners working full-time, short-term rentals often provide larger current tax savings.
- Using the tax code to your advantage may reduce overall taxable income. With the right planning, your real estate investment strategy could potentially offset taxable income from capital gains on the sale of rentals, other passive investments, crypto and stock gains, or even W-2 income.
6 Ways to Reduce Your Taxes with Real Estate
Investing in the real estate market could be a great way to build wealth while reducing your tax burden. All investors, regardless of how much time you spend in real estate, are afforded the same tax benefits of real estate investing. The only difference is the timing of when those benefits are received.
Proactive tax planning can help to may make it easier to claim rental losses, reduce your total taxable income, and offset capital gains from certain investments.
Common strategies include:
- Increasing your income without increasing your taxes
- Claiming “real estate professional” status (for long-term properties)
- Satisfying a material participation test (for short-term properties)
- Offsetting capital gains from the sale of other real property
- Offsetting income from other passive investments
- Offsetting income from crypto and stock gains
1. Increase Your Income Without Increasing Your Taxes
Investors may only claim passive rental losses if they meet the IRS’s requirements. The general rule is that for investors with an adjusted gross income (AGI) over $150,000, passive losses can only reduce taxes from other passive income. It is important to understand that this does not mean that passive investors are limited in terms of write-offs or depreciation. All investors are eligible for the same tax deductions. The only difference is “when” you can utilize the losses.
In an instance where you couldn’t reduce your W-2 taxes, you can carry excess losses forward to future tax years to offset future income. This means that the benefit isn’t entirely lost, it is simply delayed.
Example:
Bob works full time in tech and makes $500k in W-2 income. He owns one out of state rental in Texas. Bob has a property manager for the property and does not spend enough hours to be a real estate professional this year. Although Bob is a passive investor, he can still take deductions on the usual rental expenses. He can deduct his travel costs to Texas to purchase or work on the property. Bob can also claim depreciation and all real estate related expenses. Assuming the rental generated $20k of profit, Bob can use these deductions to offset the $20k of income. This means that Bob pays no taxes on his $20k of rental income.
If Bob’s rental deductions were $30k, the net loss of $10k can be carried forward into future years to offset taxes from future passive income and gains. As you can see, Bob does not lose out on the tax benefit if this $10k. He will receive a benefit for this in a future year.
Claiming Depreciation
Depreciation is one of the most powerful tax benefits of real estate investing. This is a paper write-off where the IRS allows for a “reasonable allowance for deterioration, wear and tear, and a reasonable allowance for obsolescence.”
For example, if you purchased a property where the building purchase price is $100,000, you can depreciate that $100,000 over 27.5 years. This means you can take depreciation of ~$3,600 each year to offset taxes on your rental income. Again, this is true regardless of whether you are a passive investor or not.
The great thing is that currently, we have what is known as bonus depreciation. This means you can potentially accelerate the depreciation and result in a significant deduction on the purchase price of certain items in the first year of use. These include appliances, furnishings, or even a car used primary for your real estate business. Claiming bonus depreciation can result in a net loss even if your property produces high positive cash flow.
Claiming Deductions
As an investor, you can claim tax deductions for your investment properties. The key is to have good documentation. For instance, normal business expenses are tax deductible. This includes the business use of your car. Each time you travel to stage the property, deal with guests, or manage repairs, that travel is tax deductible. Just make sure you have documentation proving the reasons for the trip.
Other deductible items may include:
- Eligible Home Office: If a portion of your home is used for your real estate business, you can potentially claim the eligible home office deduction. This strategy is possible regardless of whether you own or rent your primary home.
- Income Shifting: If you have friends or family members who can assist you in your real estate business, you can shift your income to them to reduce your tax burden. This means you would pay this family member or friend for their work on your property, and thereby reduce your taxable income.
To claim each of these deductions, documentation is imperative. Physical receipts are not required, it is perfectly fine to keep electronic copies of those in the event of an audit or IRS inquiry.
Comparing Long-term vs. Short-term Rental Rentals
Before we go into the next section, it is a good idea to start with the basics in defining long-term vs short-term rentals. The long-term rental market has historically accounted for the bulk of the real estate investment market. Over the last several years, the popularity of short-term rentals has skyrocketed thanks to the ease of online advertising and rental platforms like Airbnb and VRBO.
While long-term and short-term rentals may be similar, the IRS treats them differently for tax purposes. Let’s begin by defining what exactly is considered long-term rental vs short-term rental for tax purposes.
In general:
- A short-term rental is a property where the average guest stay during the year is seven days or fewer. It doesn’t matter where the property is advertised or listed – a tenant could rent a property for one day or one year on Airbnb. If the average guest stay is 7 days or less during the year, it is treated as a short-term rental for tax purposes.
- A long-term rental is generally a property where the average guest stay is longer than 7 days during the year. For example, if you invest in a mid-term rental where traveling nurses stay for one month at a time, this is typically treated as a long-term rental for tax purposes.
2. Claim Real Estate Professional Status for a Long-term Rental
Real estate professional status allows you to use losses from long-term rentals to offset taxes from W-2 and other income. However, claiming RE professional status could be hard for someone working a full-time job. The reason is that in order to meet the requirements, you must spend more time in real estate than your job. As you can see, for someone working 2,000 hours per year, it would be very difficult to achieve more hours in real estate.
Here is a potential strategy: real estate professional status only needs to be met by one of the taxpayers. So for a married couple, if one spouse meets real estate professional status, both of them can receive the tax benefits.
Example:
Eric and Julie, a married couple, work full time making $500,000 per year. They just had a baby, so Julie decides to stay home for one year and manage their rental properties.
As long as Julie meets the hours requirements for real estate professional status, their rental losses may be used to offset Eric’s W-2 income. Assuming they had $150,000 in losses, they would reduce their taxable income by $150,000 in the current year. Assuming they are in the 40% federal and state tax rate, this can result in $60,000 of tax savings in just one year.
Even if you aren’t able to meet real estate professional status, it is still beneficial to invest in real estate because:
- As discussed above, you can still claim depreciation and utilize tax deductions like travel, education, and the business use of your car and home office.
- You can receive passive income without increasing your overall taxes by utilizing the above tax deductions
- You can create net tax losses that can help offset taxes on future income
3. Claim Material Participation for a Short-term Rental
Short-term property owners may be able to access some power tax benefits without claiming real estate professional status. You just have to prove that you’re participating materially in your short-term rental(s).
Instead of satisfying the real estate professional test, you can obtain material participation by meeting only one of seven available tests. The most common tests to meet include:
- Spending at least 500 hours on your short-term rentals
- Spending at least 100 hours on your short-term rentals and no one else spends more time than you.
- Participating in substantially all of the activities of your short-term rentals and spend more time than everyone else combined.
There are many different tasks eligible for material participation. Here are a few examples:
- Property management
- Interacting or working with guests
- Performing repairs
- Cleaning and restocking between guest visits
- Staging the property
Want to know something else that is wonderful? If you’re married, both the hours of you and your spouse may be combined to meet the material participation test.
If you are interested in learning more about the tax strategies for short-term rental investors, be sure to read our SVIC post on the Tax Benefits of Short Term Rentals.
4. Offset Capital Gains on Sales of Other Rental Properties
Another way to use rentals to help reduce total taxes is to receive tax-fee gain. When you sell a rental property, you can use passive losses from other properties to offset this gain. Let’s go over an example.
Example
John has owned his CA rental for a few years. Since he works full-time and was passive with respect to his rental, he has accumulated about $50,000 of passive losses over the years. This year, he decides to sell his rental at the peak of the market. Upon the sale, John will receive $40k of capital gains. Because John has passive losses of $50k, he is able to use all of it to wipe-out any taxes on this $40k of gain. Further, because John disposed of the rental this year, he is able to use the remaining $10k of passive losses to offset taxes from his W-2 and other income. As you can see, this is an example to demonstrate that for all investors, you never lose out on the tax benefits from your real estate investments.
5. Offset Income from Other Passive Investments
One of the tax benefits that no one talks about is the fact that passive losses can always offset taxes from other passive income. This could be passive income from other rentals you own, passive income from syndications you invest in, or passive income from other non-real estate businesses that you invest in. A common scenario is for someone who invests passively in a syndication. If the property in the syndication is sold, you may receive a K-1 showing a large taxable gain. If you happen to have passive losses from your own rentals, those losses can be utilized to offset taxes from the gain on sale of the syndication property. Let’s go over an example using a non-real estate business.
Example:
Jill works in the tech industry as a full-time employee. With careful planning, Jill has accumulated a good amount of passive losses from her own rentals. For a few years, Jill was frustrated that she was not able to use the losses to offset her high W-2 income in tech.
Jill meets with her friend and decides to invest some of her cash in her friend’s online business. That business takes off and Jill is happy to find out that you will be receiving profit of about $30k this year on that investment. Because the online business income is passive income to Jill, she can use her rental losses to wipe out the taxes on this $30k of income. Jill is super happy that she received $30k of additional income this year that she did not need to pay any taxes on.
6. Offset Income from Crypto and Stock Gains
If you are one of the many investors who generated capital gains from the sale of stocks or crypto, consider investing in an Opportunity Zone Fund to create some tax savings. Many of these funds are set-up as syndications of real estate investments. This is a great way for you to take the gains from stocks and crypto and move it to real estate while generating some tax benefits. When done correctly, you can roll capital gains from stocks and crypto investments into a real estate opportunity zone fund. This allows you to defer the taxes on the gains and potentially obtain tax-free growth.
Example:
Let’s revisit our friend Jill from earlier. A keen investor, she decided years ago to invest in crypto.
This year, she sold a portion of her holdings which resulted in a taxable gain of $100,000. Jill then reinvested the $100,000 gain into an opportunity zone fund that holds an apartment in Atlanta. By utilizing this tax strategy, Jill was able to defer the associated taxes until the 2026 tax year.
With careful planning, her $100,000 investment grows to $300,000 over 10 years. She would never have to pay federal capital gains taxes on that $200,000 gain. This strategy not only defers her taxes but reallocates her assets to real estate for potentially tax-free growth.
Why This Matters
Contrary to popular belief, there are tax benefits to high-income earners who invest in real estate.
Most investors know that there are tax benefits to real estate investing. This is no big secret. However, where many investors fall short is with the implementation of those strategies. Simply knowing the strategies does not help you to save on taxes. To get the tax benefits legitimately, you also need to implement the strategies correctly. Without implementation, your knowledge of a tax strategy is completely useless.
As a high-income earner, you are likely paying extremely high taxes. This is why it is even more important for you to take control of your tax bill. Tax savings allows you to keep more of your hard-earned money. This means more money for you to enjoy, invest, and supercharge your wealth-building.
For more tax saving tips, be sure to check out our free tax savings toolkit!
