Investment-property taxes can be complex. This article won’t make you an expert, but it will give you a foundation of knowledge, helping you become a more savvy, successful investor.
Whether you’re accepting your first full-time job or approaching retirement, creating a financial foundation through sound investments is crucial. For most people, “investment” means the stock market. But there are other options, including investment property.
As a general rule, investment property is more complex and requires more involvement than typical stock-market investing. Taxes are a prime example. To get the most from your investment property, you need to reduce your tax burden, which means understanding how investment property is taxed and what deductions you can use for a lower tax bill.
By lowering your tax bill, you increase your chances of success with investment property!
Investment-Property Taxes: Fundamental Information for Every Investor
Note: We are not, in any way, a tax advisory service. This article should be taken as general information and entrainment only and should not be used to make any tax decisions. Before making any choice involving investments and taxes, be sure to consult a qualified tax professional.
Investment Property Taxation: Two Taxes You Need to Know
Investment-property taxes come in three different forms. You should understand all three in a broad sense, but two forms are usually the most important to investors.
Investment property taxes come as:
- Tax on regular income (Rent checks)
- Tax on capital gains (Profits from a sale)
- Estate taxes (Only applies at death)
Estate taxes are a concern for all investors, but most will be particularly concerned with taxes on regular income and capital gains.
Taxes on Rent Checks
If you place a property into the rental market, whether it’s residential or commercial, the income you generate from the property will be subject to regular income taxes, in the same way that your paycheck is subject to taxes. You must declare rental income on your tax returns, but unlike wage and salary income, you do not have to pay FICA taxes.
The income is basically anything you receive in rent from the property minus expenses. It’s important that you remember to reduce expenses, as they can have a profound impact on your tax burden. Suppose you received $18,000 in rent annually ($1,500 a month) from one of your properties, but you also spend $8,000 repairing the property. In that case, your income for the property would be $10,000. ($18,000 – $8,000 = $10,000)
But you cannot deduct every little expense from your income for your investment-property taxes. Only mortgage interest and repair that restore the property’s original functionality qualify. So new buildings, additions, and unnecessary renovations likely can’t be deducted. For this reason, it’s important that you work with a tax professional to sort out what is deductible and what is not.
Capital Gains
The other investment property tax bill that will be a concern if you become an investor is capital gains, which comes only when you sell a property. If you acquire any net profits from a property when you sell, these profits will be treated as income and added to your income.
To calculate the capital gains, simply subtract the amount you paid (including repair costs) from the amount you sold. So if you purchases a property for $500,000 and you later sold it for $550,000, your capital gains would be $50,000. ($550,000 – $500,000 = $50,000)
However, if you hold on to the property for over a year, you can enjoy longterm capital gains taxes, which are usually more favorable to the investor. The specific bill will depend on your income bracket, and could range between 0% to 15% or more.
There are slight variations depending on how long you have owned the property. If you are flipping homes and hold the property for less than a year, short-term capital gains taxes will be applied to the investment-property taxes.
Many investors use capital losses to reduce their tax burden in a given year. If you spent more than you earned, you can use capital losses to significantly reduce your tax burden.
If you are selling a property, even for a profit, and immediately reinvesting the money into a new investment property, you can use a tax code called the 1031 Exchange to avoid payments of capital gains taxes. If you are reinvesting funds from a sale, you are merely shifting your investment, so the the government allows this deduction. Without it, every time you sell a property and reinvest you would need to pay capital gains taxes.
Passive Activity Rules
These rules can be complex (again, a tax advisor is crucial!), but if you are a “passive investor,” meaning property investment is not your full time career, you are subject to passive investor rules. Essentially, the rules involved say that you can only deduct passive losses up to the point that they cancel gains from passive activities. Most individuals won’t be concerned with this rule but it can impact your investment property taxes.
As an Investor, It’s Important to Use All Available Tax Deductions
The U.S. tax code allows for a variety of deductions from your tax bill. Property taxes to cities and counties, as an example, can be reduced from your tax burden. Although the specifics on this have changed, you can reduce property taxes against your rental income.
Interest on your mortgage loan can be reduced from your tax bill, so it’s important that you keep a tab on your mortgage payments, especially the P&I section. Legal fees related to the property can also be deducted, as can mileage that you drive to and from the property. If you spend any money advertising the property, such as placing ads in local newspapers, you can deduct that expense as well.
Investment property taxes can be complex, but by understanding the basic concepts, you’ll be better equipped to reduce your overall burden!
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