When Do Real Estate Investments Become Taxable? Every Investor Should Know
Investing in the real estate industry is one of the most lucrative ways of earning passive income and diversifying your portfolio. However, as with any income and cash inflow, the government takes a cut. This cut is what we call tax.
Now, if you thought investing in the real estate sector would be tax-free, you’re in for a surprise. It isn’t. But, there are tax benefits that you can avail of. This means that even though a tax is levied, there are ways to get out of paying it, and in a perfectly legal way.
Before we jump right into the benefits, it’s important to understand the types of taxes that apply to different real estate investments. Of course, there can’t be one tax that qualifies for every type of income you make, right? That’s exactly why this post was created.
Let’s help you understand the type of taxes that different real estate investments are subjected to, and then we shall learn about the tax benefits. After all, shining a bright light on what sets the real estate investment industry apart is only fair.
Ready? Let’s go!
What Are the Taxes in Real Estate Investing?
Owning and investing in a real estate project are two very different things. When you own a property, the equity belongs to you, and any income you generate from that property will be considered taxable. Contrary to this, investing in a real estate project does not mean you own it; it simply means that you have invested a certain amount on which you will get a return when the property starts to generate rent.
Similarly, there are other types of taxes. Let’s look at some of the most important ones that every investor should know.
Real Estate Income Tax
In simple terms, real estate income means the income generated from rent received from the tenants. Any property occupied by tenants, such as an apartment, house, condo, vacation home, or any similar property, is deemed by the IRS as a rental property.
Any net income received as rent from the property is classified as income in your tax return. This income, hence, becomes taxable. Even though you call it a passive income, the IRS considers it normal income.
Now, the trick is understanding how this income can be freed from taxation. You cannot write off the entire amount, though. There are certain deductions that can lower the tax amount. For this, it is best to read the guidelines provided by the IRS regarding passive income and applicable deductions. You can also hire a tax specialist with expert knowledge to get you the highest deductions.
Property Tax
As a responsible citizen, you must pay tax on a property you own. It is also known as the real estate tax. This tax is paid to the local tax authorities or the county that works on behalf of the government. The amount of the tax varies depending on each state and local government guidelines. However, it is levied everywhere.
The government uses property taxes to develop local projects such as schools, hospitals, emergency services, roads, etc. The tax you must pay depends on your property’s assessed value, including all structures built on the land and any other improvements.
For example, if the land is vacant, the property tax will be lower than the land on which a home is built.
Capital Gains
Capital Gains taxes are applied when you sell a property at a higher value than when you bought it. It is based on the property’s appreciation during the time you owned it. When capital gains tax is calculated, the current valuation of your property is taken into account minus the depreciation.
Now, the amount of tax you will pay will depend on whether it is a short-term or long-term capital gain.
Short-term Capital Gains
The gains from the sale of a property or asset that you have owned for less than a year are known as short-term capital gains. These are treated as ordinary income and will be taxed at the normal income tax rate.
Long-term Capital Gains
Long-term capital gains are those you receive from selling a property or asset you’ve owned for more than a year. This type of gain is given a preferential tax treatment and is generally lower than your ordinary income tax rate.
Net Investment Income Tax
If you are an investor with steady and high returns, you may have to pay an additional Net Investment Income Tax. NIIT includes income such as rental and royalty income, interest, dividends, and passive income from investments that you don’t participate in actively.
IRS applies NIIT at 3.8% for certain investors only and whether or not they qualify under the MAGI clause, which clearly states the amount of income bracket to which this will be applied. The filing status is also considered for determining the income bracket, which means whether you are filing it as a single person, married, filing jointly, or married but filing separately.
Business Income Tax
If you own a property and convert it into a business such as a guest house or Airbnb, then it will be considered a business. On this, a business income tax is levied. You will need to check what type of property qualifies as a business and accordingly file the tax return.
Individual Income Tax
Individual income tax is levied on any type of income an individual earns, including salary, interest, dividends, wages, etc. If you are a real estate investor and do not own a property, you will need to pay individual income tax on the return you earn on your investment.
What Type of Taxes Are Different Real Estate Investments Subjected To?
Tax on Rental Property and Income
When you own a property and set it up on rent, you receive rent from tenants, which is known as rental income. Even if you consider it as a source of passive income, you will still be required to pay taxes on it. This tax will be liable for your net rental income.
Net rental income is the amount you get after subtracting all the expenses, including any improvements and maintenance costs. This means that you can reduce the figure of your taxable income by showing all the expenses you incurred for that rental property.
As rental income is also taxed as ordinary income, the tax rate will depend on the bracket of the income you fall under.
Tax on Accredited and Non-Accredited Investors in Crowdfunding and Syndications
The type of tax that you are liable to pay when you participate in crowdfunding or real estate syndication will depend on the type of investor you are, i.e., accredited or non-accredited. For such types of real estate investments, you will receive a K-1 tax form.
Now, let’s take a look at both types of investors and their tax obligations separately.
Accredited Investors
Accredited investors get to participate in larger real estate projects and typically get equity shares for their investments. Based on the equity share, accredited investors get rental income and capital gain upon the sale of the property.
For the rental income, the accredited investor will pay the income tax, and upon the sale of the property, the accredited investor will pay the capital gains tax.
Non-accredited Investors
Typically, non-accredited investors participate in deal deals. This means they don’t hold any equity share or own the property; they simply provide the funds for the project on which they receive interest. This interest income is classified as ordinary income, and you must pay income tax.
Tax on REITs
Investing in Real Estate Investment Trust (REIT) generates income in the form of dividends and return of capital. Typically, the majority of dividends from REITs are taxed as ordinary income.
On the other hand, the return of capital is not categorized as taxable income, but when you sell your REIT in the future, it will result in higher capital gains, and you will have to pay the capital gains tax. If the REIT is sold for a high value, the capital gains will be higher too.
Note that in the case of capital gains tax on REITs, the factor of short-term gains and long-term gains will also be considered, depending on the duration for which the REITs were held.
Tax on RELPs
Real Estate Limited Partnerships typically have two parties — the General Partner and the Limited Partner. While the General Partner is the active decision-making entity in the partnership, the Limited partner is the investor who just brings the money for the business. The Limited Partner gets a return based on his share in the partnership. Now, the tax levied on this type of arrangement is different.
Because the income is passed through the partners and they receive individual shares, RELPs are not taxed as a whole. Instead, the partnership is declared to the IRS through Form 1065. Then, the partners receive individual K-1 forms that declare the distribution of income to each of them in a given financial year. Based on this distribution of income, each investor then pays an income tax to the IRS individually.
RELPs are especially beneficial because the IRS taxes them at an individual level which makes the amount of tax paid on the income from a property much lower than at the corporate rate.
Tax Benefits of Real Estate Investing
Finally, it’s time we got down to brass tacks. The tax benefits for real estate investors are precisely what makes this the most attractive choice of investment today. If you know how to leverage the policies, you can save big bucks on your yearly returns. So, let’s help you understand the ‘hows and whys.’
Real Estate Investment Write-Offs
Following up on the ‘deductions’ addressed earlier, there are certain expenses that you can write off when calculating your net income from a property. If you own a property, any cost that you incur for management and maintenance can be deducted from the taxable income amount. These deductions include, but are not limited to:
- Exemption for homeowners in property taxes such as veteran property tax exemption and disability exemptions.
- Property management cost.
- Any cost incurred to maintain and repair the property.
- Insurance on the property.
- Interest on a mortgage of the property.
You can also write off certain real estate business expenses, such as:
- Advertising cost.
- Office space expenses.
- Any cost incurred for business equipment.
- Legal and accounting expenses.
To get the most out of the deductions, it is best to consult a legal tax specialist who can identify the loopholes and maximize savings on your income.
Depreciation
Depreciation of a property means the loss of value of the property over time. As a real estate investor who has a rental property can deduct the depreciation expense from the tax. This will lower the taxable income and save money each year.
You can calculate the depreciation on your property for the expected life of your property for the duration set by the IRS. Currently, for residential properties, it is 27.5 years, and for commercial properties, it is 39 years. Let’s try to understand this with a simple example.
Let’s say you own a residential property that you intend to put on rent. This property (excluding the land value) costs $200,000. To calculate the expected annual depreciation, simply divide $200,000 by 27.5. This comes out as $7272.72, which you can claim as depreciation on your property.
This way, you can reduce your tax liability significantly. Pretty neat, huh?!
Pass-through Deductions
As per the Tax Cut and Jobs Act of 2017, you get to deduct up to 20% of your QBI on your personal income tax. This means if you own a rental property as a sole proprietor through a partnership or LLC or an S-Corporation, the rent you receive as income will be considered as QBI.
This is due to the fact that the income is pass-through partners. If you are planning to invest in a property and earn passive income, you should speak with a tax lawyer or accountant to help you set this up. By using the pass-through deductions, you can save more on what you owe as tax.
Long-term Capital Gains
If you purchase a property and plan on selling it, you can end up paying more than necessary on capital gains tax if you sell it off within a year of the purchase. This is because long-term capital gains taxes are much lower than short-term capital gains taxes.
In some cases, you can even keep the entire profit to yourself and not pay anything in long-term capital gains. This is possible if your income from the profit (which is considered normal income) does not fall in the income bracket described by the IRS. In such cases, the filing of the return should also be considered. It is best to check the official guidelines put forth by the IRS for more clarity.
1031 Exchange
1031 Exchange is a type of reward program created by the government to encourage people to reinvest their real estate profits into new real estate deals. In this, you can buy a new property of the same or greater value than the one you sell and defer the capital gains tax.
This means you can roll over the capital gains tax from one property sale to another until you no longer exchange the property and settle with a final sale. To exercise 1031 Exchange, the following requirements must be met:
- The properties have to be exchanged for tangible assets only.
- The new property’s value must be greater than or equal to the one you exchanged.
- The property has to be held for business purposes.
Rental Income
Although your rental income is taxed as ordinary income, it is not considered earned income and hence, isn’t subject to Social Security & Medicare taxes (also known as FICA). This amount may not look like much, but it can add up to a significant number over the years.
For example, if you have taken up a job where you earn $40,000 annually, you are required to pay 7.65% towards FICA. This is equal to $3060 that you have to pay towards taxes. On the other hand, if you are earning $40,000 from rental income, you will not have to pay anything toward Social Security and Medicare Taxes.
To Conclude
Real estate investing can be more profitable if you understand the real estate investment tax strategies. There are immense tax benefits for property investors; you just need to look for them diligently.
Knowing where the deductions can be made, how they can be tweaked, and what is the amount that you would save will ultimately help you in strengthening your future real estate investment strategies. It is important to keep everything on record, even if you are spending a dollar for your investment property. Additionally, keep track of the value of your property over the years and assess the market to determine the best selling time.
Now, you don’t have to do everything alone. It is best to consult with a professional real estate tax lawyer to get the maximum benefits. But, keep yourself educated and updated with all the changes. You see the IRS has a habit of continuously changing the norms from time to time.
