Tax Credits vs. Tax Deductions: Explained

One of the perks of investing in real estate is that it typically comes with tax benefits, such as tax deductions or tax credits, that aren’t necessarily available when investing in other asset classes. These benefits can greatly enhance returns to equity but we have found that many investors are confused between the differences. In this Investor Education Post we will explain what a Tax Deduction and a Tax Credit are, how they are different, and provide some real examples.

Tax Deductions: A tax deduction lowers your taxable income, which in turn reduces the amount of income that is subject to tax. Common tax deductions for commercial property include operating expenses, real estate taxes, insurance, mortgage interest, depreciation, and capital expenditures.

For example, let’s assume a small apartment building generates $100,000 in rental income. Without any deductions this full amount would be subject to tax.  If you were in the 35% tax bracket this would equate to $35,000 in taxes.

However, let’s say this same apartment building had the following annual expenses that are eligible tax deductions:

• Property taxes: $12,000
• Insurance premiums: $3,000
• Utility bills: $7,500
• Repairs & Maintenance: $10,000
• Property Management: $5,000
• Mortgage Interest: $36,000

These expenses total $73,500 and can be deducted from the property’s rental income to arrive at its taxable income: $100,000 – $73,500 = $26,500.  These deductions have lowered the property’s taxable income from $100,000 to $26,500. If you were in the 35% tax bracket this would equate to $9,275 in taxes, instead of $35,000 due prior to the deductions.

In this example, $73,500 in tax deductions lowered taxes due by $25,725.

Tax Credits: A tax credit is a direct reduction in the amount of tax that you owe. For example, let’s assume you owe $50,000 in taxes after considering all of your income and tax deductions. A tax credit of $10,000 would directly lower your tax bill by that same amount, decreasing it to $40,000.

Tax credits are available for special types of property classified by the IRS or local government to have societal or environmental benefits. Examples include low income housing, historic preservation, or improvements to property for energy efficiency (such as solar).