Landlords get all the same tax breaks that you do on the houses they own – and live in – but, in addition, landlords also get a ton of additional tax breaks on ALL their rental properties that you don’t get on your one house.
Invisible Subsidies to Landlords of Single-Family Houses
The tax code essentially pays investors to buy single-family houses which corrupts price signals, distorts the free market, and lowers home ownership for people like you who actually live in their homes.
Here’s a partial summary list of landlord tax breaks (tax incentives) on single-family houses in the U.S.
Depreciation. Landlords get annual “depreciation” tax deductions even when the house appreciates in value! The house could go up $100,000 in a year and the landlord would still get a tax reduction for (non-existent) depreciation. This one tax deduction lowers home ownership two different ways. The tax break on imaginary depreciation makes it, 1) more profitable for landlords to buy and own houses and, 2) less profitable for landlords to sell houses because of the depreciation recapture tax they might pay when they sell. The fact that landlords get a tax deduction for “depreciation” on appreciating rental houses shows how incredibly distorted the U.S. tax code is in favor of landlord ownership of single-family houses.
Bonus Depreciation. If that's not crazy enough, in recent years, right when house prices and landlord purchases were skyrocketing, landlords were getting "bonus" depreciation so they often paid zero income taxes for several years even though they were pocketing big money from their rental houses and the value of their rental houses was skyrocketing in real life.
1031 Exchange. After they sell a rental house, the 1031 Exchange rules in the tax code let landlords defer paying ANY capital gains taxes on the sale – often forever – if they buy another property. Investors can't defer paying capital gains taxes when they sell stocks or bonds, so the 1031 Exchange gives investing in single-family houses and condos an advantage over other investments, and more investor money chases homes.
Mortgage Interest & Property Taxes. All landlords can deduct from their taxes all the state and local property taxes and mortgage interest they pay on all their rentals. Only about 12% of personal income tax filers even itemize their tax returns which is needed for live-in home owners to be able to deduct their property taxes and mortgage interest payments from their taxes.
No Social Security Taxes. The landlord next door doesn’t have to pay Social Security or Medicare taxes on their rental income or on their profits when they sell the house like you do on your ordinary wage and salary income.
Tax-Free Profit Taxing. Landlords can take capital gains profits tax-free by doing cash-out refinancings. In addition, the interest on their new cash-out, profit-taking, refi mortgage is also tax deductible.
Capital Gains Tax Rate. The tax rate on landlord capital gains – when and if paid – is usually a lot lower than the taxes the live-in home owner next door pays on their ordinary wage and salary income.
Pass-Through Business Deduction. A 20 percent tax deduction for income from sole proprietorships, partnerships, LLCs, REITs, trusts, and S corporations.
Reduce Tax Paid on Ordinary Earned Income. In some cases, the paper (tax) losses on rental properties can reduce taxes owed on ordinary earned income.
Stepped-Up Tax Basis. The stepped-up tax basis on the death of the landlord makes owning rental houses a good way to reduce their estate taxes, and those reduced taxes increase the demand to own rentals, at least for people who want to minimize their estate taxes.
Tax Treatment of Losses. When a landlord loses money selling a house, the loss becomes a tax deduction for the landlord but when a home owner loses money selling the house they live in, it isn’t a tax deduction.
Let me know the landlord tax breaks I’ve missed.
“If you invest in real estate and you're paying taxes then you're doing it wrong" - Clayton Morris.
In addition, you may be pocketing money on your rentals and not paying taxes on the income but, in some cases, owning the rentals can REDUCE the amount of taxes you owe on your other income!
The tax code does NOT allow you to rent your house to yourself so primary-home owners can’t take any of those landlord tax breaks.
The demand from investors to buy and own single-family rentals is, to a large degree, driven by the tax code, not the free market.
Landlords aren't the problem. The problem is the tax code.
There are several things that require clarification in your list.
1) Depreciation is real, though a non-cash expense. Depreciation is the loss of value in a property due to maintenance costs (which increase over time) & obsolescence (represented by the need to upgrade the property over time).
2) Cash-out refinances are simply borrowings which have no impact on the taxable gain on sale of the property. The gain is calculated based on the basis of the property, not the borrowing of funds that are not used to improve the property. And interest on the borrowing is not deductible unless the funds can be traced to property improvements or the purchase of a new rental.
3) Capital gain rates are the same for individual investors (landlords) & homeowners. Homeowners can exclude up to $500,000 of gain on the sale of a primary residence if certain conditions are met (e.g., own the home & use it as a primary residence for two of the five years prior to sale). That's one reason why it may be a good idea to convert a rental to a primary residence in order to exclude a large portion of the gain on the sale of a property.
4) The pass-through business deduction or qualified business income deduction is available to investor / landlords who are in the trade or business of renting properties. This isn't typically for investors in a single rental, but may be available if several rentals are owned. It is another non-cash expense which makes investing in rentals a lot more profitable.
5) Losses on rental properties may be deductible under the passive loss rules against "active" income like wages. The passive loss rules are far more complicated than can be explained here - but they are critical to making the tax rules work for the investor.
6) The basis step-up rules are a valuable planning tool for managing income tax liability for the individuals who inherit rental property. Whether or not the inheritance is maintained as a rental or is sold, the basis step-up eliminates all capital gain prior to the death of the individual investor / landlord.
7) Tax treatment of losses is another big item in tax planning. Even if passive losses are not deductible in the year incurred (see note above about the complications of the passive loss rules), it is often possible to trigger passive losses in the year of sale to offset the capital gain generated by the sale of the rental. It may be better to sell the rental than to execute a §1031 exchange because of the triggering of these passive losses in the year of sale.
8) It is possible to reap additional benefits from being a real estate professional for tax purposes. This requires a great deal of documentation in order to prove that an investor / landlord qualifies for these additional tax benefits.
Although real estate investment is a very tax advantaged investment opportunity, I don't agree with the comment by Clayton Morris. The cash flow savings from tax breaks are often tax deferrals which may become permanent under certain circumstances. The cash flow savings allow for the faster accumulation of wealth, but the economics of the rental are always the primary consideration.