A key difference between owing investment property and property that youlive in is that you can deduct far more expenses on your taxes than you can for your own residence. All typical and necessary expenses used to generate taxable income from rental property can be deducted against rental income, which you report on Schedule E of form 1040. If you buy and sell properties as your investment, rather than renting them, you’ll be taxed on capital gains rather than rental income, but you’ll still report your expenses on Schedule C. 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 investment. This article is not going to make you an expert. but we hope to acquaint you with a few facts.
Rental Income Is taxable
Yes, rental income is taxable, but that doesn’t mean everything you collect from your tenants is taxable. You’re allowed to reduce your rental income by subtracting expenses that you incur to get your property ready to rent, and then to maintain it as a rental. The IRS taxes in two primary ways… Income tax and capital gains tax. Estate tax only applies after death of the owner.
Rental income is taxable. That means you must declare it as income and pay tax on it. Unlike wages, rental income is not subject to FICA taxes. The income is all rent payments and royalties on the property, minus expenses. You can deduct mortgage interest and repairs. You can not deduct capital investments like new buildings, addition, or renovations.
Capital Gains Tax
This applies when you sell the property if you make a profit. If you are flipping and have only owned the property for less than a year, you pay short-term capital gains tax which is the same rate as your marginal tax rate. If you are in the 28% tax bracket, you will pay 28% on short term capital gains. If you own the property for one year you will qualify for a more favorable long term capital gains which can be 0% to 15% depending on your marginal tax bracket.
Calculating Capital Gains
When you sell rental property, you’ll have to pay tax on any gain (profit) you earn (“realize,” in tax lingo). If you lose money, you’ll be able to deduct the loss, subject to important limitations. Your gain or loss for tax purposes is determined by subtracting your property’s adjusted basis on the date of sale from the sales price you receive (plus sales expenses, such as real estate commissions). Your basis in property (the amount of your total investment in a property for tax purposes) is not fixed. It changes over time to reflect the true amount of your investment. This new basis is called the adjusted basis because it reflects adjustments from your starting basis. Reductions in basis can increase your tax liability when you sell your property because they will increase your gain. Increases in basis will reduce your gain and therefore your tax liability.
Deferring Capital Gains Tax
There is an IRS provision that is an important exception to capital gains taxation. This provision is a made to order for real estate investors: If you own investment property you can sell your property at a profit and roll your money over into another property within 60 days without paying capital gains taxes at all. This exchange is called like-kind exchanges you could not swap your rental property for a personal residence or vice versa.
Depreciation and Amortization
Overtime property decreased in value. Depreciation is the process of claiming a deduction to compensate you for the property’s decrease in value during the year. You can only depreciate investment property not your personal residence. Land does not depreciate. The IRS does not allow deduction of the full cost of your investment in the first year. You must amortize your investment over a number of years. For real estate you must spread the deduction out over 27.5 years.
Rental Income Passive or Active
Tax law specifies that all rental activities are passive activities, even if the landlord is a material participant, unless the taxpayer is a qualified real estate professional or the rental businesses are classified as active businesses by the tax code. Hence, losses from rentals can only be deducted from other passive income. Theses rules are complex. Most individual investor landlords can deduct up to $25,000 per year in losses on rental properties. Hopefully you will not have to make use of this provision.
You can deduct property taxes against your rental income. Expect to pay property taxes to city and county governments each year. Property taxes are a type of “ad valorem tax’ the term is Latin for “according to value” — so it follows that they’re calculated based on an assessment of your property’s value. Local property taxes fund schools, fire departments, and libraries, and they can be a major source of funding for your city and county. Some property tax bills show details on how much of your money goes to specific government and public expenses.
Other Tax Deductions
- Home Office Deduction
- Advertising Fees
- Lawyers Fees
- Mortgage Interest
Tom has 20+ years experience in helping his clients buy and sell properties. Tom is also great resource for trusted vendors that can help assess and fix a property before buying or selling it.
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