There are certain things you can do as a real estate investor to help manage your tax bills, and maximize your after-tax return on your investment. In order to do so, however, you need to understand the primary ways in which investment real estate portfolios get taxed. You must also have a general grasp of some abstract concepts like calculating your tax basis, as well as the depreciation of capital investments.
Warning: This article will only arm you with enough information to be dangerous. This article is not going to make you an expert. But you can become conversant with the basic terminology, so you can be better prepared for a meeting with your tax advisor.
Taxation of Rental Income
The IRS and most states tax the real estate portfolios of living investors in two primary ways – income tax and capital gains tax. The estate tax only applies to dead investors and will not be discussed at length in this article because it involves a whole different set of rules and planning strategies. Rental income is taxable as ordinary income tax. That means individuals have to declare it as income on your tax return, and pay income tax on it by April 15th of the year after the calendar year that you receive it.
Rental income receives better tax treatment than income earned from wages – you don’t need to pay FICA taxes on rental income, while you do have to pay FICA on wages you earn for work, such as those on your W-2. Your income is everything you get from rents and royalties on the property, minus any deductible expenses. You can’t deduct everything, though – while you can deduct mortgage interest, repairs, maintenance, real estate taxes, HOA fees, and more, you cannot deduct capital investments like new buildings, additions, most improvements, or renovations.
Capital Gains Tax
The second tax bill you need to worry about is capital gains tax. The IRS and most states taxes you on any net profits you get out of a property when you sell it. If you’re “flipping” properties and you own the property less than a year, you pay short-term capital gains, which is the same rate as your marginal income tax rate. If you’re in the 28 percent tax bracket, you’ll pay a 28 percent tax on short-term capital gains.
If you hold onto the property for at least 366 days then you will qualify for more favorable long-term capital gains. Depending on your marginal income tax bracket, these taxes could range from zero to 20 percent. In every bracket, however, Uncle Sam takes a smaller cut out of long-term gains than out of ordinary income or short-term gains.
If the house you are selling qualifies as your primary residence, which generally means that you or your spouse owned and lived in the house for 2 of the previous 5 years, then you can exclude the capital gain up to $250,000 for single taxpayers and $500,000 for married filing jointly taxpayers. There are a few requirements to meeting this exclusion.
Calculating Capital Gains
You pay capital gains tax on the difference between your selling price in the property and your tax basis. Your basis in a property is the total amount of dollars you have invested in the property for which you have not taken a deduction. This starts with your purchase price and increases to account for the amount invested in renovations and improvements (including labor costs on these projects). If you have claimed depreciation as a tax deduction, then you subtract that from your tax basis. If your basis is higher than your sale, you have a capital loss. You can subtract capital losses from capital gains to reduce your tax bill. If you have more losses than gains, you can “carry forward” these losses into future years, to cancel out capital gains in future years and then to cancel out up to $3,000 in ordinary income. (Note, if you take a capital loss on a property, you cannot buy the same or substantially identical property back for at least 30 days, under so-called “wash sale” rules.)
How To Defer Capital Gains Taxes Indefinitely – An Intro to Like-Kind Exchanges
The IRS provides an important exception to capital gains taxation, made-to-order for real estate investors: If you own an investment property, you can sell your property at a profit and roll your money over into another property within 60 days without having to pay capital gains taxes at all – a transaction known as a Section 1031 exchange, named for the section of the U.S. Revenue Code that allows it. It has to be a property of “like kind.” You cannot swap your rental property for a personal residence, or vice versa. For this reason, these exchanges are sometimes called like-kind exchanges.
The 1031 exchange makes it possible for real estate investors to defer paying capital gains tax almost indefinitely – which is another advantage over investing in mutual funds, stocks, bonds and other securities or collectibles. Outside of a retirement account, you typically have to pay tax on gains in these items by the April 15th in the year after you sold them.
Depreciation and Amortization
This is a broad and detailed concept, so I will only cover the very basics here. When you buy investment property – be it a building, a computer or a horse – the IRS knows that the item won’t stay young and new forever. Over time, the property will decrease in value. Depreciation is the process of claiming a deduction to compensate you for the property’s decrease in value during the year. Note: You can’t depreciate your personal residence. You can only depreciate investment property. For more information on the process of depreciation, see IRS Publication 946 – How to Depreciate Property.
Land, of course, doesn’t depreciate. But minerals underneath the land do. If you are extracting oil or other minerals, or timber, for that matter, from the land, you will account for the gradual loss in value through a process called depletion.
Likewise, when you make a purchase of investment real estate or capital equipment with a useful life of longer than a year, the IRS knows you will be using that property to generate income for a long time to come. Except in certain circumstances, (Section 179) the IRS does not allow you to deduct the full cost of your investment in the first year. Instead, you must amortize your investment over a number of years. For residential real estate, you must spread the deduction out over 27.5 years, and for commercial real estate 39 years.
Passive Activity Rules
Again, these rules are complex. But in a nutshell, if you are a passive investor – meaning you are not working day to day in the business of managing your real estate investments – you are subject to passive activity rules. Basically, you can only deduct passive losses to the extent you can cancel out gains from passive activities. These rules restrict your ability to use passive activity losses to offset capital gains elsewhere in your portfolio. Congress implemented these rules in 1986 to eliminate tax loopholes and abusive tax shelters. So thank your parents and grandparents for ruining it for you. And their accountants.
Most individual investor landlords can deduct up to $25,000 per year in losses on rental properties, if need be, depending on their income level. Real estate professionals can deduct an unlimited amount of rental real estate losses, but the definition of real estate professional is a strict definition.
Just as Uncle Sam takes his cut, so do his local nieces and nephews. Expect to pay property taxes to local and county governments each year. Your local government will assess the market value of your property at its “highest and best use,” and charge you a percentage of that value every year. You can deduct property taxes against your rental income, though, provided the property tax is uniformly assessed throughout the jurisdiction and is not a special assessment. Most counties allow you to claim a “homestead exemption,” which reduces the real estate tax due on your primary residence.
Other Tax Deductions
Be on the lookout for opportunities to take deductions for these common real estate investment expenses:
- Mortgage interest
- Legal fees for business purposes (but not for personal reasons)
- Mileage and travel
- Advertising fees
- HOA fees