Editorial Integrity
Making sound real estate investment decisions begins with reliable, data-driven insights. At Ziffy.ai, we offer an AI-powered investment property search platform, proprietary data-driven trend analysis, investment mortgage programs like DSCR loans, and a network of over 500 investor-friendly real estate agents to deliver the expertise needed for informed decisions. Our content is crafted by experienced real estate professionals and backed by real-time market data, ensuring you receive accurate and actionable information. Through a rigorous editorial process, we strive to empower your investment journey with trustworthy and up-to-date guidance.
Key Takeaways:
1. Property taxes vary by state and directly impact your yearly returns. Knowing your local rate helps you plan your operating expenses accurately.
2. Rental income is fully taxable, but smart deductions can lower your bill. Mortgage interest, property taxes, insurance, and depreciation can offset a large portion of your rental income, reducing your overall tax burden.
3. Depreciation lowers taxable income each year but comes with recapture rules. The IRS requires you to pay taxes on the total depreciation claimed when selling, up to 25 percent.
4. A 1031 exchange can defer both capital gains and depreciation recapture. By reinvesting your proceeds into another property within IRS timelines, you can grow your portfolio without paying taxes immediately.
Table of Contents
Real estate investing in the US is not just about finding the right property and collecting rent. Real estate taxes play a big role in shaping your returns, and understanding how they work can save you thousands of dollars over the life of your investment.
From property taxes you pay each year to capital gains when you sell, every stage of ownership comes with specific rules. The more you know about them, the better you can plan, reduce liabilities, and protect your profits.
Property Taxes
Property taxes are charged by local governments based on the assessed value of your property. They are one of the most predictable costs you will face as an investor.
-
Rates vary widely. In Hawaii, average effective rates are under 0.3 percent, while in New Jersey they can exceed 2 percent. - For rental properties, property taxes are deductible on Schedule E, which reduces your taxable rental income.
- For primary residences, property taxes are subject to the state and local tax (SALT) deduction limit, which is capped at 40,000 dollars starting in 2025.
Rental Income Tax
If you earn rental income, you should know that the IRS treats rental income as taxable income. The good news is that you can offset this income with a variety of deductions.
Deductible expenses include:
-
Property taxes - Mortgage interest
- Insurance premiums
- Repairs and maintenance
- Property management fees
- Depreciation
What remains after deductions is your net rental income. This is taxed at your ordinary income tax rate.
Depreciation
Depreciation is one of the most valuable benefits of owning rental real estate.
- Residential rental property is depreciated over 27.5 years.
- Only the value of the building is depreciable. The land is not.
- Major improvements, such as a new roof or HVAC system, also have to be depreciated rather than deducted in full in the year you pay for them.
Depreciation reduces taxable income every year, which can be especially powerful if your property is cash flow positive. However, the IRS requires you to account for depreciation when you sell through a process called recapture.
Capital Gains Tax on Sale
When you sell a property, any profit is subject to capital gains tax.
- Short term gains apply if you hold the property for one year or less. These are taxed at your ordinary income rate.
- Long term gains apply if you hold the property for more than a year. These are taxed at favorable rates of 0 percent, 15 percent, or 20 percent depending on your income level.
- High earners may also owe the 3.8 percent Net Investment Income Tax.
Depreciation Recapture
Depreciation reduces your taxes during ownership, but when you sell, the IRS wants some of that back. The portion of your gain equal to the depreciation you claimed is taxed at a maximum rate of 25 percent.
Example: If you deducted 50,000 dollars in depreciation, that amount is recaptured and taxed separately when you sell, even if your overall gain qualifies for the lower long term capital gains rates.
1031 Exchange
A 1031 exchange is one of the most powerful tax deferral tools available to investors. It lets you sell an investment property and reinvest the proceeds into another without immediately paying capital gains tax or depreciation recapture.
To qualify:
- You must identify the replacement property within 45 days of the sale.
- You must complete the purchase within 180 days.
- A qualified intermediary must hold the proceeds during the exchange.
This strategy allows you to build wealth by rolling gains into larger or better properties while deferring taxes indefinitely.
Home Sale Exclusion
If you sell a property that has been your primary residence for at least two of the past five years, you can exclude a portion of the gain from taxes.
- Up to 250,000 dollars for single filers
- Up to 500,000 dollars for married couples filing jointly
Keep in mind that any depreciation you claimed while the property was used as a rental is not excluded. That portion is always subject to recapture.
Conclusion
For investors, taxes are just as important as location and cash flow. Property taxes impact your operating expenses every year. Rental income taxation and depreciation shape how much you owe each filing season.
When it comes time to sell, capital gains and depreciation recapture can take a big bite out of your profits unless you use strategies like a 1031 exchange. And if you are selling a home you lived in, the Section 121 exclusion can shelter a significant amount of gain.
The bottom line is this: smart investors plan for taxes from the start. With the right approach, you can protect your returns and grow your portfolio more efficiently.
FAQs
Do property taxes differ by state?
Yes. Property tax rates vary widely. Some states are relatively low, while others have some of the highest effective tax rates in the country.
Can depreciation help me even if my property makes money?
Yes. Depreciation is a non-cash expense that lowers taxable income. It can make a profitable property show little or no taxable income for years.
What if I do not claim depreciation?
You still have to pay depreciation recapture when you sell, whether or not you actually claimed it. Not claiming it only hurts you.
Can any property qualify for a 1031 exchange?
No. Only investment or business properties qualify. Primary residences and foreign properties do not.
Can I avoid paying capital gains tax altogether?
You cannot completely avoid it, but you can defer it indefinitely with a 1031 exchange or exclude a portion of it with the home sale exclusion if the property was your primary residence.
