Basic Guide to the Tax Implications of Real Estate Investments

Whether you have just closed on your first rental unit or are a seasoned real estate professional flipping multiple properties, it is important to understand how real estate investments are taxed. As the year comes to an end, sit down with a trusted financial advisor to make smart decisions to manage your tax bill and increase the returns on your investment.

Real Estate Income and Capital Gains

Anyone who invests in real estate actively or passively (more on that later), may find their income or profits subject to government taxes. There are two ways your real estate portfolio might be taxed: as personal income or as capital (profit) on a sale.

Here is a basic guide to common real estate taxes and some options for keeping more of your money in the investment or in your pocket. Work with a tax professional to ensure you take each credit and deduction you are eligible to receive and make a plan to claim them on your taxes to your best advantage.

Rental Income and Common Deductions

For those individuals who lease their property to tenants, the money you receive as rent must be declared as ordinary income on your tax return. Corporations with leased properties may need to

declare their rental income quarterly. Rental income is everything you get from rents and royalties on the property, minus any deductible expenses. But what qualifies as a deductible expense?

Rental property owners can only deduct mortgage interest and repairs which restore the property to its original minimally functional condition. Repairs and maintenance expenditures can be deducted the year you spend the money.

More extensive repairs, new landscaping, installing energy-efficient windows and doors, renovations and additions which may allow you to increase rents are considered capital investments. These expenses may increase the value of the property and need to be depreciated over 28 to 40 years. That also means you may need spread out your deduction over a long period of time, so don’t expect to earn it all back in April.

Be on the lookout for other deductions on legal and tax preparation fees, gas mileage and use of your home office for business purposes, advertising fees and even employees. Some of these deductions are one time while others are annual or amortized over several tax years. Ask your tax professional if you or your corporation is eligible.

Capital Gains Strategies

Individuals or corporations who earn profits through the buying and selling of real estate may be subject to capital gains taxes. Your tax liability will depending on federal requirements and how long you own the property. If you “flip” a property in less than a year, you will be subject to short-term capital gains, which is the same rate as your marginal income tax rate. If you hold your property for more than a year you may qualify for less tax liability with a tax on profits that range from about 1 to 15%. Consider adjusting the timing of a home sale to minimize exposure to the net investment tax.

Take account of any gains or losses in your real estate portfolio. To calculate your capital gains (or loss) subtract any sales costs, the original purchase price and the cost of capital improvements from the sales price, then account for depreciation you claimed on the property.

If you bought a property for $180,000, sold it for $250,000, paid $11,000 in commission fees, invested $30,000 on improvements to the property and claimed $15,000 in depreciation over the past four years ($250,000-$11,000-$180,000-$30,000+$15,000) your capital gain would be about $44,000. After four years you would qualify long-term tax rate of 15 percent tax of $6600 (which is about half the liability associated with a short-term capital gains rate assigned to an owner in the 28 percent tax bracket).

Requirements to Claim Capital Gains

Tax laws may be changed, enhanced or withdrawn by the government; review the requirements to file and take advantage of special offers while they last. Under 2014 tax law, many people may find they do not have to include gains in their taxable income.

Single tax filers who have resided in a house for two of the previous five years owe taxes on $250,001 in profit and up. For married couples filing jointly the threshold is $500,000 in profit. Any

profit beyond the threshold is subject to capital gains tax (unless you qualify for special exemptions due to a job loss or illness). These favorable tax terms may expire in 2015, so plan accordingly.

1031 Like-Kind Exchanges

For those with a taxable capital gain, you can sell your property at a profit and roll that money over into another similar property (rental for rental, etc.) within 60 days without having to pay capital gains taxes. You cannot swap your rental property for a personal residence or vice versa. This transaction is known as a Section 1031 or Like-Kind Exchange. Essentially you could continue to avoid capital gains taxes by continually rolling any profit back into your investment portfolio.

Carry Forwards

If your capital basis is higher than your sale, you have a capital loss. Real estate investors may subtract those losses from gains to reduce their tax liability. Recognize losses to offset earlier gains from previous tax years or carry the loss forwards to offset any capital gains distributions or sales that might create a gain in future tax years.

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.

Choosing an Advantageous Investment Structure

Passive investors, active “real estate professionals” and select business entities may be subject to different capital gains taxes. Passive investors – meaning you are not working day to day in the business of managing your real estate investments – are restricted to claiming select losses to offset taxable income. Active “real estate professionals” – those spending at least 750 hours a year and more than 50% of your work time on real estate – with adjusted gross income less than $100,000 may include losses from passive activities for up to $25,000.

If you are flipping properties for profit — and you are continually turning a profit — in the short-term or long-term you may want to consider operating as an S corporation, LLC or other business entity for better tax terms and lower personal liability.

Set Your Tax Plans

Work with your trusted financial advisor or tax professional to review your real estate investment portfolio for ways to save on taxable income or profits. You may choose to reinvest in your rental properties with deductible repairs and improvements, take advantage of current thresholds for claiming gains, time your sales for the best tax terms or offset your past or future gains with capital losses. Use the years end to set a plan and make smart moves before the next tax filing deadline.

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