Learn how to understand the complex tax regulations that apply to investment properties, as well as how to save money on taxes. As a real estate investor, there are a few things you can do to assist control your tax burden and optimizing your after-tax return on investment. To do so, you must first comprehend the most common methods by which investment real estate holdings are taxed. You’ll also need a basic understanding of some abstract concepts like calculating your tax base and capital investment depreciation.
Taxation on Rental Income
The IRS taxes living investors’ real estate holdings in two ways: income tax and capital gains tax. (A third option, the estate tax, is exclusively applicable to deceased investors.)
Rental income is taxable in the same way that regular income is. That implies you must report it as income and pay income tax on it on your tax return. Rental income is not subject to FICA taxes, unlike wages.
Your income is calculated by subtracting any deductible expenditures from the rentals and royalties you get from the property. You can’t, however, subtract everything. Only mortgage interest and repairs that return the property to its original minimally usable condition are deductible. Capital investments, such as new buildings, extensions, or restorations, are not deductible. These will be discussed in greater detail later.
Capital Gain Tax
The second tax bill you need to worry about is capital gains tax. When you sell a property, the IRS taxes you on any net gains you make. If you’re flipping a house and have only had it for a year, you’ll have to pay short-term capital gains tax, which is the same as your marginal income tax rate. Short-term capital gains are taxed at a rate of 28 percent if you’re in the 28 percent tax bracket.
If you keep the property for a year, you’ll be eligible for more favorable long-term capital gains tax treatment. These taxes might range from 0% to 15% of your gross income, depending on your marginal tax level. Long-term gains, on the other hand, are taxed at a lower rate than regular income or short-term gains in every bracket.
Calculating Capital Gain
The difference between the property’s selling price and your adjusted tax base is subject to capital gains tax. Your adjusted tax basis in a property is the original purchase price plus any money you put into renovations and upgrades (including labor expenditures) that you haven’t already deducted from your taxes.
If you have any property-related deductions, you deduct them from your tax base. You have a capital loss if your adjusted tax basis is larger than your selling price. You can lower your tax payment by deducting capital losses from capital gains in a given year and “carry forward” capital losses into future years to offset future capital profits if you have greater capital losses than capital gains. If you have no capital gains, you can deduct $3,000 every year until all of your capital loss carryforwards has been recognized.
How to Defer Capital Gain Taxes?
The IRS has created a special exemption from capital gains taxation for real estate investors: If you possess investment property, you can sell it for a profit and invest the proceeds in another property within 60 days of selling it without paying any capital gains taxes. This is referred to as a Part 1031 exchange, after the section of the Internal Revenue Code that permits it. Your rental property cannot be exchanged for a personal house, and vice versa. As a result, these transactions are known as like-kind swaps, because the item you replace it with must be substantially comparable to the one you sold.
Real estate investors can avoid paying capital gains tax by using the 1031 exchange, which is an advantage over investing in mutual funds, stocks, bonds, and other securities or collectibles. If you sold these things outside of a retirement plan, you must pay tax on the profits by April 15 of the following year.
Depreciation and Amortization
We can just touch on the absolute fundamentals because this is such a wide subject. When you acquire an investment property, whether it’s a building, a computer, or a horse, the IRS understands that it won’t last forever. The property’s worth will depreciate over time. Depreciation is the process of claiming a tax deduction to reimburse you for the decline in value of your property over the course of the year.
It’s important to note that you can’t depreciate your own house. Only investment property can be depreciated. See IRS Publication 946, How To Depreciate Property, for further information on the depreciation process.
Land, on the other hand, does not depreciate. Minerals, on the other hand, are found beneath the surface of the ground. If you remove oil or other minerals from the soil, or timber for that matter, you must account for the steady decrease in value due to a process known as depletion.
Similarly, when you buy investment real estate or capital equipment with a useful life of more than a year, the IRS knows you’ll be utilizing it to produce revenue for a long time to come.
The IRS does not enable you to deduct the whole amount of your investment in the first year unless you meet specific criteria. Instead, you must spread out your investment over a period of time. The deduction for real estate must be spread out over 27.5 years.
Passive Activity Rules
These are, once again, complicated rules. In a word, if you are a passive investor — that is, if you are not actively managing your real estate assets on a day-to-day basis — you are subject to passive activity laws. In general, you can only deduct passive losses to the degree that earnings from passive activity can be canceled. These limitations limit your ability to offset capital gains elsewhere in your portfolio with losses from passive activities. These regulations were enacted by Congress in 1986 to close tax loopholes and abusive tax shelters.
If required, most individual investor landlords can deduct up to $25,000 per year in rental property losses (subject to income limitation). Hopefully, you won’t need to utilize this feature very often.
Property Taxes
Each year, you should expect to pay property taxes to the municipal and county governments. Your local government will determine the “highest and best use” of your land and charge you a percentage of that value each year. However, if the property tax is equally levied across the jurisdiction and is not a special assessment, you can deduct it from your rental income.
Other tax Deductions
Keep an eye out for deductions for the following frequent real estate investment expenses:
- Mortgage Interest
- Mileage
- Business use of your home (the office-home deduction)
- Legal fees related to your investment properties or businesses
- Employees (but if they are working on capital improvements or renovations, you have to amortize their labor costs as part of your capital investment, rather than as a current year expense.)