One way or another, Uncle Sam is going to get his cut. Count on it. And so will your state and local governments. That said, there are certain things you can do as a real estate investor to help manage your tax bill, and maximize your after-tax return on your investment.
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. Hey, if this stuff were easy, we’d all be CPAs, right?
Warning: This article is not going to make you an expert. But it will aquaint you with the basic terminology, so you can be better prepared for a meeting with your tax advisor. You can click on any of the links for more detailed information from the Internal Revenue Service.
Taxation of Rental Income
The IRS taxes the real estate portfolios of living investors in two primary ways: income tax and capital gains tax. (A third way, estate tax, applies only to dead investors.)
Rental income is taxable — as ordinary income tax. That means you have to declare it as income on your tax return and pay income tax on it by April 15th of the year after the year you receive it. (Corporations may have to declare this income quarterly.)
Your income is everything you get from rents and royalties on the property, minus any deductible expenses.
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 get from a W-2 (and double FICA on self-employment income). It’s almost as if the system is rigged against the working man!
Your income is everything you get from rents and royalties on the property, minus any deductible expenses. You can’t deduct everything, though. You can only deduct mortgage interest and repairs you make that restore the property to its original minimally functional condition. You can’t deduct capital investments like new buildings, additions or renovations. More on these later.
Capital Gains Tax
The second tax bill you need to worry about is capital gains tax. The IRS 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. And you’ll like it, by God!
Ok, maybe not. But you’ll pay it. Unless you can hang on to the property for at least 12 months. In that case, you will qualify for more favorable long-term capital gains. Depending on your marginal income tax bracket, these taxes could range from zero to 15 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. And once again, we see the system favors the landlord investor over the worker.
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, from your purchase price to the amount invested in renovations and improvements (including labor costs on these projects). If you have deductions associated with the property, you subtract them from your tax basis. If your basis is higher than your sale, you have a capital loss. You can subtract losses from a given year from 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 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. This transaction is known as a Section 1031 exchange, named for the section of the U.S. Revenue Code that allows it. 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 have to pay tax on gains in these items by April 15th of the year after you sold them.
Depreciation and Amortization
This is a broad concept, so we can 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.
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.
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 (hopefully that applies to all your real estate!), the IRS knows you will be using that property to generate income for a long time to come. Except in certain circumstances, then, 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 cars, you have to spread your deduction out over five years. For real estate, you must spread the deduction out over 25 years. For more information on how to account for amortization and depreciation on your tax return, you can download the IRS instructions.
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 that 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. Hopefully you won’t have to make use of this provision much.
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.
Other Tax Deductions
Be on the lookout for opportunities to take deductions for these common real estate investment expenses:
- Mortgage interest
- Tax advice and preparation fees
- Legal fees for business purposes (but not for personal reasons)
- Business use of your home (the home office deduction)
- Advertising fees
- 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.)