5 Tax Advantages That Make Real Estate Investing So Powerful
How to legally reduce your taxes while building wealth (including one strategy that lets you defer taxes indefinitely)
One of the things that makes real estate investing so special is the way it is treated from an income tax perspective. This is true both during your ownership of a property and at the time of a sale.
There are at least five tax advantages of real estate investing:
Depreciation: reduces your taxable income while you own it.
Refinancing: refinancing a property is not a taxable event.
Capital Gains: as long as you own the property for at least one year, the gain from a sale is treated as long-term capital gains.
1031 Exchange: if you sell a property and buy another one of “like-kind” within 180 days, you are able to defer your tax until you sell the second property.
Step-Up in Basis: when you die, your heirs get a new tax basis at the market value of the property.
All of these can be combined to allow you to keep more of your money.
You don’t need to be an accountant or a math major to take advantage of these. You just need to know they exist and work with a qualified tax accountant to put the tax laws to work.
Let’s dig in.
A quick public service announcement before we get into the details.
In these newsletters, I am guiding you through the world of real estate investing. In some areas, I will be able to give you enough detail to be very knowledgeable.
In others, I will give you the high level overview but will not be able to give you nearly enough details to be self-sufficient without an expert.
Tax is one of these areas.
People spend their whole career learning all the details of tax accounting and the changing laws. There is no way to cover this level of detail in a newsletter.
So take this information for what it is: an initial guide to help you identify opportunities and ask the right questions of the experts.
Here we go…
The Basics of (Federal) Income Taxes
In order to understand the tax advantages of real estate investing, we need to cover some basics of federal income tax.
Do you really know how income taxes work in the United States? Maybe you understand the concept, but not the details.
Here are the basics.
The money you earn (income) is treated in four main ways:
Ordinary Income: your salary/bonus.
Passive Income: real estate income, royalties, passive businesses.
Dividends: from stocks.
Capital Gains: from selling stock, real estate, a business, etc.
It can get more complicated than this, but these four are the basics that will affect most people including real estate investors.
Ordinary income is the least tax efficient, which is taxed up to 37% at the highest tax bracket.
For many taxpayers, the long-term capital gains rate is 15%, but it can be 0% for lower incomes.
Big difference.
Note that dividends from stocks are unique. Some are taxed as ordinary income. Some are taxed as capital gains.
Now most of us won’t pay 37% tax on our ordinary income. Federal income tax works on a sliding scale. As of 2025, it starts as low as 10% and scales up to 37%.
Example: if you are single and earn $100,000, your taxes will be:
10% on the first $11,925 = $1,192.50
+ 12% on the amount between $11,926 and $48,475 = $36,550 x 12% = $4,386.00
+ 22% on the amount between $48,476 and $100,000 = $51,525 x 22% = $11,335.50
= Total tax of $16,914 or 16.9% effective tax rate.
Once you have higher income, taxes get much higher. For example, a married couple making $500,000 would pay 22.8%. If they earn $1M, they would pay $29.4%.
You can find the data to do the math on your income here: https://turbotax.intuit.com/tax-tools/calculators/tax-bracket/
But what about passive income from real estate investing?
Passive income generally follows the same tax brackets as ordinary income but has the ability to be reduced by passive losses (example: depreciation). We will get more into this in the next section.
Remember that all of this is only the federal tax, not state tax.
What about state taxes? They are different in each state. Some are zero (Texas, Florida). Some are on a sliding scale (California). You will have to research that on your own.
Now we have the basics of how taxes work, let’s explore the five magical aspects of taxes as they relate to real estate investing.
Depreciation
Key Benefit: reduces taxes on cash flow from real estate investments. You pay less (or no) tax on the cash flow you get while owning the property.
The concept behind this is that you have to pay money to buy the property, but the property will depreciate (i.e. get run down) over time. From a maintenance perspective, it would be better to own a brand new building than one that is 30 years old.
So here is how it works.
You buy a property for $3,900,000. After discussing with your tax accountant, you allocate $1,150,000 of the cost to the land and $2,750,000 to the building. You only depreciate the building, not the land.
If it is an apartment or a 1-4 unit residential investment, you can depreciate it over 27.5 years per the tax rules. Office, industrial, and retail are depreciated over 39 years.
Continuing our example: $2,750,000 allocated to the building divided by 27.5 = $100,000 per year.
This $100,000 is a non-cash expense that you deduct from your income each year.
Let’s say you are earning 7% per year on the $3,900,000 investment = $273,000 per year. You reduce it by the $100,000 of depreciation to $173,000 of taxable income.
$273,000 cash flow - $100,000 depreciation = $173,000 taxable income.
You don’t have to pay tax on $100,000 of the income which would have been taxed at the 24% or even 32% tax bracket. Pretty cool!
It gets even more powerful if you have a loan on the property.
For example, you borrow 50% of the cost of the property. 50% x $3.9M = $1.95M. For simple math, assume your interest rate is also 7% so you have “neutral” leverage.
Don’t worry if you don’t understand the debt part. We will get to it in a later session.
Instead of earning $273,000 per year, you only earn half of this as the other half goes to pay debt service.
50% x $273,000 = $136,500.
Reduce the $136,500 by $100,000 in depreciation leaves you with only $36,500 of taxable income.
$136,500 cash flow - $100,000 depreciation = $36,500 taxable income.
Amazing!
It is almost tax free.
If can get even more powerful if you do a “cost segregation study”, which allows you to depreciate some parts of the buildings like plumbing, flooring, and interior walls faster. We won’t go into the details here. All of this is based on the Modified Accelerated Cost Recovery System in the U.S. tax code.
Can I use depreciation to reduce the taxes related to my salary/bonus (ordinary income)?
No.
You cannot use depreciation (passive losses) from real estate to offset your salary/bonus (ordinary income) unless you meet certain qualifications as a real estate investor. Most people will not meet these qualifications. Consult with your tax accountant to understand if you qualify. Passive losses can only offset passive income.
Key Takeaway: depreciation is a non-cash expense that will reduce your taxable income and taxes from real estate investing each year while you own an investment property.
Most of the income I get from my LP investments discussed in past newsletters is shielded by depreciation, allowing me to keep all of the cash flow I get while paying little to no tax on it. See 5 Ways to Invest in Real Estate (From $60 to All-In).
Refinancing
Key Benefit: proceeds (i.e. cash) you receive from a refinance are not considered a taxable event.
We will keep this one short and sweet.
You increase the value of a property and put more debt on it. Example: you increase the debt from $1,000,000 to $1,500,000.
You payoff the original loan and have a “cash out” refinance of $500,000.
$1,500,000 new loan less $1,000,000 original loan = $500,000 of excess cash you keep.
The IRS does not view this as a taxable event. Wow!
You will still need to pay off more debt eventually, but it is nice to have the cash now to reinvest.
I have had many “cash out” refinances in my investing history.
Key Takeaway: refinances are a tax efficient way to pull cash out of a property that has increased in value.
Capital Gains
Key Benefit: if you own an investment property for at least one year, you pay a lower tax rate on profits from the sale of that property as compared to ordinary income.
This is true for not only real estate investments, but almost all investments. Other examples are:
Sale of a business you created or bought.
Sale of stock.
There are two terms to learn here:
Long-term capital gains relate to investments held for at least one year.
Short-term capital gains relate to investments held for less than one year.
Long-term capital gains have a sliding scale just like ordinary income but it ranges from 0% to 20% depending on income. Higher earners may pay an additional 3.8% (Net Investment Income Tax), making the maximum 23.8%. To geek out on the details, you can go to the IRS page here: https://www.irs.gov/taxtopics/tc409
For the rest of you, just remember that long-term capital gains are what you want when you sell a property as they are almost always lower than short-term capital gains which are taxed the same as ordinary income discussed above, which ranges from 0% to 37%.
One more thing…
The negative side of depreciation comes into play here. Remember the $3.9M property example from the depreciation section. Let’s assume we held the property for three years and enjoyed the benefit of $100,000 per year of depreciation for a total of $300,000.
Our tax basis at time of sale is $300,000 less than when we originally bought the property.
$3,900,000 minus $300,000 = $3,600,000.
If we sell the property for $4,900,000 we will have $1,300,000 of gain.
$4,900,000 minus $3,600,000 = $1,300,000.
This is $300,000 more of gain than if depreciation did not exist.
But, we are paying a lower tax rate on this $300,000 as compared to the savings we got by not paying ordinary income on that same $300,000. It is more complicated than this, but it typically works to a taxpayer’s advantage.
Key Takeaway: if you are going to sell your investment property, try to hold it for at least one year to make your capital gains long-term, which are taxed at a lower rate than if you held it for less than one year.
Is there even a way to avoid long-term capital gains? Not exactly, but they can be deferred.
1031 Exchange
Key Benefit: if you sell your investment property and buy another one of “like-kind” within 180 days, you defer the taxes from the sale until you sell the second property.
This is pretty cool. As far as I know, this is unique to real estate investing.
Let’s continue with our example.
You bought a property for $3,900,000 and sold it after three years for $4,900,000. You find a new property to buy for $4,900,000 and “1031 exchange” into that new property.
This is not a taxable event because it is not considered a sale for tax purposes.
No sale.
No long-term capital gains.
No tax.
You can do this over and over again from property to property.
Just be careful to follow the rules and meet the qualifications:
It must be of “like-kind”. In simple terms, it must be another investment property.
You must use a “qualified intermediary”. Think of this as a 3rd party you pay to make sure you follow the tax rules.
The new (replacement) property or properties must be of the same or greater value as compared to the one you are selling.
You must identify the new property within 45 days of selling your property. You can identify up to three properties.
You must buy the new property within 180 days of the sale of the old property.
This can be a complicated and expensive process as you will be paying the qualified intermediary, but the tax deferral benefits can be significant.
Additionally, if you don’t do a 1031 exchange when you sell the second property, then your capital gains will be even higher than if you had just bought the second property with “fresh” cash because your tax basis will be equal to the tax basis from the first property.
Said another way, the old tax basis from the property you sold carries forward to the new property you bought.
Key Takeaway: if you buy a new property within 180 days, you can defer the capital gains tax from a property you are selling.
But what if you never want to pay long-term capital gains? There is an option, but it has its downsides.
Step-Up in Basis
Key Benefit: when the owner of a property dies, the heirs (or surviving spouse) get a step-up (increase) in tax basis to the market value of the property at time of death.
I told you that you weren’t going to like it.
You or a loved one are dead.
Here’s how it works:
The property owner dies.
The property is valued at market as of the date of the owner’s death.
The tax basis of the heirs (or surviving spouse) is the market value.
This is true for not just real estate, but anything owned by the person who dies including stocks, a home, a business, etc.
Note that this is different from estate (inheritance) tax. Estate tax is a 40% tax that the estate (not the heirs) pays on inheritance over an amount set by the IRS. As of 2025, it is just under $14M per person ($28M for married couples). This reduces the amount the heirs ultimately receive.
Example: if you and a sibling inherit $20M of assets from an unmarried parent, the math would be:
$20M less $14M IRS allowance = $6M x 40% = $2.4M in estate tax.
$20M less $2.4M in estate tax = $17.6M in after tax inheritance.
Remember that 1031 exchange we did? The tax basis would be increased to the market value at time of death. This is the way to ultimately avoid the capital gains tax from the sale of a real estate investment.
Just remember it comes with a meaningful cost: you or a loved one need to die.
Key Takeaway: when someone dies, all assets they pass on to their heirs or surviving spouse (including real estate investments) gets a “step-up” in tax basis to the market value at time of death.
Summary
We have covered a lot.
Let’s recap the summary we started with:
Depreciation: reduces your taxable income while you own it.
Refinancing: refinancing a property is not a taxable event.
Capital Gains: as long as you own the property for at least one year, the gain from a sale is treated as long-term capital gains.
1031 Exchange: if you sell a property and buy another one of “like-kind” within 180 days, you are able to defer your tax until you sell the second property.
Step-Up in Basis: when you die, your heirs get a new tax basis at the market value of the property.
You don’t need to be an expert in any of this. You just need to remember that they exist and work with a tax accountant who understands real estate investments.
Side note: as a real estate investor, you want to assemble the right team. Turbo Tax or the tax accountant you are currently using as a salaried employee and stock investor may not be the right fit for you as a real estate investor. Ask around and take the time to find the right accountant.
Most important: remember that real estate investing has many tax advantages that will benefit you both during your ownership of a property (depreciation reduces taxable income) and when you sell a property.
Are there more tax advantages I am missing? Email me at bateman@creprofessor.org to let me know. As a life-long learner, I am always looking to grow.
Professor Bateman
Special thanks to my anonymous friend and real estate tax specialist who helped me fact check this and add clarity where needed. You know who you are. I appreciate you!