Investments

What Qualifies As An Investment Property

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 12 minute read

The tax advantages of real estate investing are significant. To reduce their tax liability, investors might plan how they acquire and sell properties. However, much like the rest of the United States Tax Code, the regulations can get complex very rapidly. Make sure you know the tax advantages and laws before diving deep into real estate investing to avoid giving more money than necessary to the government.

What Kinds of Real Estate Income Are Taxable by the IRS?

There is a wide variety of real estate revenue models. The source and length of time you’ve owned the property affect how the IRS taxes it.

Gains in the Short Term

Short-term capital gains taxes are due when an asset is sold for a profit within a year after purchase. The principle is universal, and it can be applied to any asset class.

You could, for instance, invest $100,000 in a home, spend $50,000 refurbishing it, and then sell it eight months later for $200,000. To put it another way, if you made $35,000 after closing and carrying costs of $15,000. Also, come tax time, the Internal Revenue Service gets a portion of your earnings.

Gains on investments held for a year or less are taxed by the Internal Revenue Service at the same rate as ordinary income. If your profits from short-term investments put you in the highest tax bracket, at 22 percent, you must pay that rate on those gains.

Gains in Long-Term Capital

Taxes on long-term capital gains are due when an asset is held for a year or more before being sold. There are fewer taxes and that’s the difference. The Internal Revenue Service generally taxes long-term capital gains at a lower rate, 15% for middle-class workers and 0% for Americans making less than $40,400 ($80,800 for married couples) in tax year 2021.1 

This is done to encourage long-term investment in the economy. Long-term capital gains tax rates in the United States are 20% for those who make over $445,851 as a single taxpayer or $501,601 as a married couple.

Income from Real Estate Dealers

According to the Internal Revenue Service, a dealer is somebody whose major business purpose is the acquisition of property for the purpose of reselling.

The Internal Revenue Service will now tax you in a different manner because of this. Your profits will be taxed as if they were earned through a legitimate business. 

That means you’ll be responsible for paying your own taxes as an employer (effectively, double FICA) and won’t be able to use tax strategies like 1031 exchanges or installment sales to put off paying taxes.

When it comes to house-flipping, the lines tend to blur. You can call yourself a real estate dealer if you flip properties as your primary occupation and complete at least a dozen transactions annually. 

House flipping can be considered noncommercial activity if the flipper has a day job in a completely different industry and just flips one house on the side.
Consult your accountant when in doubt.

Rental Income

Rental income is subject to the same taxes as other sources of income. There are many options available to help investors in real estate income minimize their tax liability.

Real Estate Investments Have Tax Advantages.

Real estate investors, as you look into strategies for reducing their tax liability, keep in mind the many tax breaks available on investment properties.

Depreciation

Suppose you could reduce your taxable income by the amount you paid for each investment property you bought. Basically, you can’t act like that. Although devaluation gets close.

Buying a rental property entails investing in both the land and the structure on it. The cost of a structure, as opposed to the cost of land, can be depreciated over a period of 27.5 years by the Internal Revenue Service.

That’s like a tax break, except you’ll have to take the deductions across many years. Spreading out the deduction can be done by dividing the total building cost by 27.5 and deducting that amount annually until you’ve deducted the full amount. 

Similarly, capital improvements, or large-scale renovations that increase the building’s useful lifespan, are eligible for depreciation. On the other hand, you’ll have to make a payment to the IRS to cover depreciation recapture if you sell the property. 

To put it another way, it’s like getting a loan from the Internal Revenue Service without having to pay anything back. Luckily, there are other methods, such as a 1031 exchange, that can help you avoid or postpone paying depreciation recapture.

Many Tax Deductions

When investing in real estate, every cost can be written off or depreciated. Your rental revenue will be reduced by these above-the-line deductions. That is, you don’t have to itemize them because you deduct them directly from your gross personal income before figuring out your tax bill.

Common tax write-offs for investment properties include:

  • Final Closing Costs in Full. Some closing costs can be deducted in the year they are incurred, while others must be depreciated in tandem with the cost of the building as a whole. Your accountant will see it clearly in the settlement statement.
  • Putting money toward a mortgage. Your effective interest rate could go down after mortgage interest is removed.
  • Restoration and Maintenance. Likewise, you can deduct the money you spend on maintenance and repairs. Always keep in mind the difference between routine upkeep and substantial remodeling. As an illustration of a necessary repair, consider the installation of new windows. If you wish to boost your home’s value and energy efficiency by replacing all the windows, you can’t write off the entire cost in one year, but you can write off 27.5% of the cost every year for 27.5 years.
  • Utilities. Any payments made for utilities by a landlord are eligible for a tax deduction.
  • Payment to the Property Manager. The fee you pay to a property manager is an investment expense that can be deducted from your profits.
  • Taxes on the Profit from Real Estate Investments. Your rental income will be lowered not just by the expense of upkeep but also by the cost of paying real estate taxes. Since they are business expenses, they cannot be deducted by the taxpayer.
  • Landlord insurance. Landlord insurance is a must to safeguard your investment in rental properties. The difference between this policy and a conventional one is that it covers only the building and not the belongings inside. Tenants’ possessions are not protected by the landlord’s insurance in the case of a fire and should be insured by a separate renters insurance policy.
  • Pricing for Professional Advice. To reduce your taxable income, you can deduct some business expenses, such as accounting, bookkeeping, and legal fees.
    work-from-home job. While employees are no longer eligible for the home office deduction, real estate investors still have the option to take advantage of it. Due to the possibility of an audit by the IRS, this requirement must be strictly adhered to.
  • Food and getting about. For tax purposes, real estate investors can deduct the full amount of their housing and food expenses incurred when traveling to and from a rental property. If you are already an investor, remember that you can only deduct half of your meal expenses when you visit your investment property. These write-offs are risky but allowable in the same way that a home office is. Don’t let anything slip through the cracks in your documentation.

Absence of Self-Employment Taxes

As a long-term investor, you can avoid paying self-employment taxes by buying and holding. Still, they can take advantage of the tax breaks available to them as independent contractors.

They qualify for all the enticing tax breaks, such as the home office deduction, the transportation expense deduction, and the food expense deduction. Accounting fees, legal fees, and fees paid to other professionals are all deductible. To top it all off, they can still claim the maximum standard deduction.

The 20% Pass-Through Deduction

Investing in real estate may make you eligible for the 20% pass-through deduction. As much as 20% of your eligible business income can be subtracted from your overall taxable business revenue. Years after the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), which established it, the regulations and applications relating to it are still complicated.

You need to have qualifying business income and an annual income of less than $157,500 ($315,000 for married couples) to qualify. Second, you should never mix business and personal funds. Establishing a limited liability corporation (LLC) and a dedicated bank account are the first steps in this direction.

It’s imperative, though, that you put in at least 250 hours each year of effort treating your real estate investing venture like a legitimate business. Timesheets detailing your activities for each hour worked are required as proof. Prior to filing this, you should consult a tax expert.

Tax Deferral Options for Capital Gains

A few options are open to real estate investors to postpone paying capital gains taxes. They may occasionally put off paying them indefinitely.

Payment Plan Sale

When a seller provides a large portion of the financing for a buyer’s purchase, the transaction is known as a seller-financed installment sale. To rephrase, instead of getting a loan from the bank and making payments to the bank, they make their mortgage payments straight to you.

It allows you to take your taxable capital gains gradually over several years rather than all at once. So, your yearly taxable income won’t skyrocket. Let’s say you made the final payment on a home you purchased 25 years ago for the full price of $50,000. 

The current market price for the property is $300,000. Profit before taxes might be $250,000 if closing expenses and renovations were offset by each other.

To the IRS, a middle-class person would owe 15% of the amount ($37,500). This high earner owes the IRS $50,000, or 20% of his or her income. All of it would be owed with your upcoming tax return.

You offer the buyer a 15-year mortgage in exchange for financing the property. That might be enough to maintain your capital gains tax rate at 0% on an annual basis, depending on your income. Your effective tax rate could go down even if a portion of your income stays at 0% and the rest goes over the 15% threshold.

Buy into Opportunity Zones

With the passage of the TCJA, opportunity zones were established. If investors immediately reinvest their capital gains into an opportunity fund, they may be able to defer or even completely avoid paying taxes on the profits. 

The properties owned by these funds are located in eligible opportunity zones, which are parts of the country that have experienced economic hardship. The tax savings from owning shares in a mutual fund get larger the longer you keep them there. Shares may be exempt from capital gains taxes if held for at least 10 years.

However, this tax technique has a time limit imposed by the original law. Investments in a qualifying opportunity fund must be made before January 1, 2027, in order to qualify for the tax break under the current rules. Within 180 days after selling an asset, you must also invest the proceeds in one of these funds.

Before putting your money into these mutual funds, you should familiarize yourself with the topics most frequently addressed by the Internal Revenue Service.

1031 Exchange

To defer paying capital gains tax on the proceeds from the sale of an asset, a 1031 exchange, also known as a like-kind exchange, allows you to invest in another property right away.

Growing your real estate portfolio and your revenue from it can be facilitated by a like-kind exchange. If you’re a young adult, you can acquire a small single-family rental property that brings in $150 per month and use that money to start investing. 

Having built up some equity and savings, you decide to sell it a few years later and invest the money in a three-unit building that generates $450 a month in rent. In another five years, you’ll repeat the process to purchase an eight-unit building that will bring in $1,500 per month in rent.

All of this is accomplished with zero capital gains tax due. You’ll owe capital gains tax when you sell your property for personal gain rather than reinvestment.

Ways to Completely Avoid Capital Gains Taxes

Each and every tax obligation is not unavoidable. Some capital gains taxes can be avoided with smart planning.

Taxes, Not Death

Keeping your moneymaking assets intact is the simplest course of action. Throughout your working and retirement years, you can continue to get passive income from your investments. All of your property will be added to your estate after you pass away. Your heirs will be responsible for paying the capital gains taxes after your passing.

Nonetheless, this isn’t always the case. Before everything else, when you die, the cost basis of your assets is usually recalculated. In financial accounting, your cost basis is the initial outlay that was made to acquire an asset. It serves as a starting point from which capital gains or losses can be calculated.

Let’s say you spent $100,000 on a piece of real estate and its value increased to $1,000,000 the day you passed away. There would have been capital gains taxes to pay on the $900,000 profit if you sold it while you were still living, with the cost basis being $100,000. Tax reasons will use a $1 million cost basis after your death. Your heirs would not have to pay capital gains tax if they sold it for that amount.

The majority of estates actually end up owing zero federal estate taxes. However, several states charge their own estate taxes even on smaller estates, and the first $11.7 million of an estate will be exempt from federal estate tax in 2021. Equity in your home can be withdrawn before your death if you choose to do so.

Loans Can Help You Cash Out Your Equity

You may begin to see dollar signs when you consider the equity in a property you own that is worth $1,000,000 or more. It’s time to put some of it to use.

Alternatively, you may put the house up for sale. But now you’re stuck with not one but two issues: The first order of business is to pay any applicable capital gains taxes to the federal government. Worse, you will never again receive any rent or other passive income from that asset.

The answer? You can avoid selling your home and still get a loan by using the equity in it. Your capital gains tax bill is zero. In other words, your source of passive income is not interrupted. Even when your income is reduced, you can write off mortgage interest payments.

This allows you to receive a lump sum from your equity while also having your renters contribute toward your mortgage.

Obtain a 2-year Lease on the Property.

Property owners are free from paying capital gains tax on profits made from the sale of their primary residence. When you sell your primary residence, the first $250,000 of your profit is not subject to taxation under the Section 121 exception, also called the primary residence exclusion. 

Those who are married are eligible for a $500,000 tax-free profit. You need to have made this place your permanent abode for at least two of the past five years to be eligible.

Real Estate Investing with a Self-Directed Roth IRA

You are likely already familiar with how a Roth IRA operates you are required to pay taxes on your contributions, but any earnings or money you take out of the account is free of taxation.

The typical investor sets up a Roth IRA with their stockbroker and uses the funds to buy stocks and bonds. However, some seasoned pros in the real estate industry go the extra mile and establish a self-directed individual retirement account.

To put it simply, people have complete discretion over their funds and can use them for virtually any purpose. For example, rental properties are considered investment properties.

This type of account, however, requires more time and money to maintain than a standard Roth IRA. You shouldn’t start one until you’ve honed your skills as a real estate investor and are confident in your ability to outperform the stock market with your investment properties.

The Tax Breaks for Property Flippers

Most of the tax breaks available to landlords and other real estate investors are not available to those who flip houses. They may also be required to pay self-employment taxes as a real estate dealer, depending on their volume, in addition to paying taxes on their short-term capital gains.

The same deductions are available to them, including those for home mortgage interest and moving costs incurred in the course of doing business. Also, it’s reasonable to deduct expenses like food, transportation, and even a home office from your income.

To reduce or eliminate your exposure to capital gains tax while flipping a home, consider turning it into a primary residence in the interim. You buy a house that needs work, move there while it’s being renovated, and keep living there.

The capital gains tax rate is reduced from ordinary income tax rates to long-term capital gains tax rates if you hang on to the investment for at least a year. For the Section 121 exclusion to apply, you must keep it for at least two years.

Bottom Line

Investments in real estate can yield returns in the form of both capital appreciation and rental income. Inflation and time both add value to that income, and the tax breaks just speed up that growth.

While it’s true that understanding the tax benefits of real estate investments can be a challenge, investors can use tax tactics to lower risk and boost returns. Before attempting anything too complex with your tax approach, be sure to retain the services of competent tax professionals.

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