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Updated about 1 year ago,
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What is the Difference Between Tax Deductions and Tax Credits?
Real estate is an investment vehicle that comes with a lot of tax benefits which is why it is so attractive to investors. However, understanding the tax benefits and really grasping the difference between tax deductions and tax credits can be crucial to your portfolio as it can significantly impact your bottom line.
What are tax deductions?
A tax deduction lowers your taxable income by taking your gross income and subtracting qualified expenses. Your taxable income is the portion that is subject to taxation, so by lowering your taxable income, you pay less in taxes.
Credits, as we will discuss next, reduce the amount of tax that is owed dollar for dollar whereas deductions lower your taxable income. The actual tax savings is dependent on the taxpayer’s marginal tax bracket and does not have a dollar for dollar impact.
Let’s walk through an example. An individual has $49,000 in gross income and $6,000 in deductions (qualified expenses). Their taxable income would then become $43,000. If you assume they have a 20% tax rate, the $6,000 in deductions would translate into a $1,200 tax savings ($49,000 x 20% = $9,800 in taxes — $43,000 x 20% = $8,600 in taxes — $9,800 - $8,600 = $1,200 savings.)
What are tax credits?
Tax credits are different from deductions because they decrease your taxes on a dollar for dollar basis rather than lowering your taxable income. You can think of a credit as a discount on your taxes. Depending on your financial situation, you may save only a few dollars or you may save thousands of dollars. There are eligibility requirements and dollar amounts that vary widely depending on the credit.
Let’s walk through an example. An individual has $49,000 in gross income and $6,000 in tax credits. If you assume they have a 20% tax rate, they would have a tax liability of $9,800. However, after you apply the $6,000 of tax credits, they only have a remaining tax liability of $3,800. You can see how this differs from the tax deductions example above.
Tax credits can also be refundable whereas tax deductions cannot. This means that if you have $5,000 in credits but you only owe $4,000 in taxes, you can receive a refund of $1,000. Using tax credits strategically is very important as this could put more money back in your pocket to invest in your portfolio.
As always, I highly recommend working with a CPA that specializes in real estate taxation to try to maximize your tax benefits. Here are a couple additional resources of tax credits available to both individuals and businesses.
Businesses | Internal Revenue Service (irs.gov)
Credits & Deductions for Individuals | Internal Revenue Service (irs.gov)
What tax credits do you utilize in your real estate portfolio?