The Tax Benefits of Residential Rental Property

IIt was the 16th amendment to the Constitution in 1913 that allowed the federal government to impose taxes based on a percentage of income. In 1921 profits on assets such as real estate were differentiated from income and subjected to lower taxes to give a boost to investment and business. In later years some percentage of real estate profits were excluded from taxation altogether. Although rates and rules change regularly through the years, the underlying purpose of lower, differentiated taxes for real estate remains the same: to benefit and promote investment.



Depreciation
The IRS defines depreciation as an "income tax deduction that allows you to recover the cost . . . of . . . property over the time you use the property." To figure out the deduction you take the cost of the asset and divide it by a term provided by the IRS. The term, or "useful life," for buildings is 27.5 years. The deduction for a building that cost $1,000,000 is $36,364 per year for 27.5 years. Capital improvements to the building, like new furnaces, roofs and kitchen, are depreciable as well. You subtract the deduction annually, along with all other deductions, from the property's income. If the property's income is less than the deductions, you pay no taxes. It is possible, then, to make a profit off rents but pay no tax because of depreciation. Depreciation is a truly beneficial tax benefit pertaining to rental property.
Expenses
The expenses required to buy, run and maintain residential rental property are all deductions. The question is not so much "what is considered an expense?" but "what isn't?" Mortgage interest, all maintenance costs, property taxes and utility costs are the obvious deductions. However, even expenses distantly related to the property are considered deductions: business supplies like paper and stamps used to write your tenants letters, your mileage when you drive back and forth between your office and the property and part of your accountant's bill for doing your taxes. Expenses are fully deductible in the year they are made.
Capital Gains
Profits on the sale of rental real estate, called capital gains, are taxed at rates lower than those on ordinary income if they are held for more than one year. The more money you make, the more you save on capital gains, because ordinary income tax rates go up to over 30 percent with income, but capital gains rates are capped at 15 percent.
Deferred Exchange
While capital gains allow you to limit taxes on real estate profits, a deferred exchange, also called a 1031 exchange, allows you to defer them for years and, potentially, forever. In a deferred exchange a third party holds the money that comes out of your sale of property until you find a replacement property to purchase with the funds. You must identify the property within 45 days from the sale, and close escrow within six months. The property must cost more than the price you sold the last one for; any money you decide to take yourself will be taxed. Via sfgate

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