Working for a company is the most common way people in the United States earn their living. As an employee, your earnings are reported on IRS Form W-2, and federal, state, Medicare, and Social Security taxes are withheld every time you are paid.
Although there are benefits to being an employee—like simplified tax preparation—you may pay more in taxes than self-employed individuals or business owners because you can’t claim certain deductions. That doesn’t mean you don’t have options, however. You may be able to supplement your income, grow your net worth, and reduce your tax obligation by investing in real estate.
Understanding Real Estate and Tax Basics
An investment in real estate can be used to lower the overall taxes you pay, including your W-2 income. This is done by using certain tax strategies, like depreciation, 1031 exchange, deducting mortgage interest, and taking advantage of tax credits. Your ability to use real estate tax deductions to offset your W-2 income from investment losses may be limited by the “passive loss rules,” however.
A passive loss occurs with a rental property when the operating expenses exceed the rental income. If one of your rental properties suffers flood damage, for example, and you don’t have flood insurance, the repairs could be more than your rental income in a year, depending on the severity of the damage.
There is an exception to the passive loss rules for the 2024 tax year if you qualify as a “real estate professional.” A passive real estate investment is one in which you do not materially participate, like renting apartments or single-family homes.
If your adjusted gross income is $100,000 or less and you incur a loss from your rentals in a tax year, you may be able to use the loss to offset non-passive income, like W-2 income, for up to $25,000 if you are a real estate professional.
To qualify as a real estate professional in the eyes of the IRS, you must meet two criteria:
- Material participation: You are actively involved in the operation of your real estate investments. The IRS provides several tests to determine material participation.
- Time spent: You must spend more than 50% of your working time in a tax year materially participating in your real estate investments. This is to make sure your real estate activities are your primary occupation.
If you believe you qualify as a real estate professional, it’s important to keep detailed records of your participation in your real estate activities to prove it. If you are audited, you’ll need proof of the hours you worked and the nature of your involvement.
Real Estate Strategies for Reducing W-2 Taxes
There are several ways that you may be able to reduce your W-2 taxes with a real estate investment. The type and whether you have an equity or debt investment determines the strategies you will qualify for.
Direct ownership and rental properties
Owning long-term rentals lets you grow your net worth almost on autopilot. Other than making sure your rentals are maintained and a few other tasks, this strategy can be mostly passive.
The most common way investors reduce W-2 taxes with rental real estate is by depreciating their properties. Depreciation is an accounting strategy that allows you to deduct a portion of the purchase price of your property on your taxes each year until the full amount has been deducted. Remember that the depreciated value of a property is not the same as its market value.
For a residential property, the IRS allows you to depreciate it over a period of 27.5 years in 2024. For commercial properties, the depreciation period is 39 years.
Real estate investment trusts (REITs)
A real estate investment trust (REIT) is a way to invest in real estate without having to deal with tenants, maintenance, and other time-consuming real estate issues. REITs are companies that own and operate income-producing properties. They invest in many different types of properties, including residential, commercial, industrial, and others.
Although some REITs are privately controlled, many are publicly traded on stock exchanges, which makes them highly liquid investments. Income from a REIT is received as a dividend.
Although a REIT does not directly lower your W-2 taxes the same way as rental properties, there are some indirect ways that it may provide tax benefits. REIT investors can benefit from tax-deferred growth on their investments, for example, if they are held in tax-advantaged accounts such as IRAs or 401(k) plans. Qualified dividends may also be taxed at capital gains tax rates in 2024, which are lower than the rates for ordinary income.
Real estate crowdfunding platforms
In recent years, a new way to find real estate opportunities has made it easier to invest. Real estate crowdfunding platforms operate entirely online and allow you to pool your money with other investors for certain projects. You can browse many different opportunities and crunch the numbers to see which ones appeal to you.
The best real estate crowdfunding platforms offer different types of investments, including single-family homes, apartments, commercial properties, industrial properties, and real estate development projects. You can invest in income-producing properties or act as a lender and earn interest.
If you are a W-2 earner investing through a crowdfunding platform, the tax implications will depend on whether you are a debt or equity investor. And if you are lending money (debt investing) to earn interest, the interest is taxable as ordinary income in 2024.
If you are an equity investor who earns investment income, you may be subject to capital gains tax if you sell your investment for a profit. You may also be able to take a depreciation deduction for the portion of the property you own.
More Advanced Real Estate Tax Strategies
If you are an experienced investor, you may be considering a 1031 exchange or investing in an opportunity zone. Both strategies may help you save on capital gains taxes in the current tax year. Here’s a look at each.
1031 exchange
A 1031 exchange is a strategy that allows you to defer the capital gains tax when you sell a property for a profit. Named after Section 1031 of the IRS tax code, some people refer to it as a “like-kind” exchange because you purchase an investment property that is similar to the one you just sold: You essentially swap one property for another.
This strategy doesn’t eliminate the capital gains tax, however—it just postpones it. The tax will eventually need to be paid. The main benefit of a 1031 exchange is that it gives you more money to invest in a new property when you sell.
Opportunity zones: investing in economic development
An opportunity zone is an area that the government believes will benefit from economic development to spur job creation. They are usually low-income communities with older homes and few businesses. Real estate investors can take advantage of certain tax benefits by investing in qualified opportunity funds (QOFs), which invest in businesses or real estate projects in opportunity zones.
An important benefit of investing in a QOF involves the deferment of capital gains tax. If you sell an investment property and reinvest the proceeds in a QOF within 180 days, you can defer paying the capital gains tax until you sell your investment in the QOF or until Dec. 31, 2026, whichever comes first.
Seeking Professional Advice
Coming in at nearly 7,000 pages, the U.S. tax code is complex and changes every year. Because it’s important to make sure your taxes are prepared correctly, be sure to seek the help of a tax professional. Some real estate tax strategies are complex—like 1031 exchanges—so you want to make sure you get everything right.
Seeking the advice of a financial advisor is also a good idea if you are considering certain real estate strategies. A financial advisor can provide expert guidance and may make recommendations to help you reach your investment goals faster and save money on taxes.
Finding someone to help you with your investment strategy and taxes has never been easier. With the BiggerPockets Tax & Financial Services Finder, you can quickly find an investor-friendly professional near you.
Final Thoughts
Investing in real estate for W-2 employees offers many benefits that go beyond tax savings. You could invest in rental properties, for example, to supplement your future retirement income. If you use the monthly rental income to make the mortgage payments, the notes will eventually be paid off, and you will own the properties free and clear. You can then enjoy mostly passive income in your retirement years, or sell your properties for a lump sum.
With careful planning, a real estate investment can also be used to lower the taxes you pay on your W-2 income. In addition to helping you save money, your investment will also appreciate over time, making it a strong hedge against inflation.
Before you take a tax deduction or credit, be sure it’s permitted in the current tax year. The tax code is amended every year, and something that is a tax break one year may not be the next.
If you are unsure about a particular tax strategy, a tax professional can ensure that your taxes are prepared correctly and that you take every legal deduction and credit that you are due.
Related IRS Publications and Resources
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
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