Investment Property: How Much Can You Write Off on Your Taxes?
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. To do so, you need to understand how investment real estate portfolios get taxed. Below is some information to get you acquainted with the basic terminology.
Taxation on 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. Your income is everything you get from rents and royalties on the property, minus any deductible expenses. You can only deduct mortgage interest and repairs that restore the property to its original minimally functional condition. You can’t deduct capital investments like additions or renovations. Unlike wages, rental income is not subject to FICA taxes.
Capital gains tax is a tax on any net profits you get out of a property when you sell it. If you’re flipping the property and you’ve owned it for less than a year, you pay short-term capital gains tax, which is the same rate as your marginal income tax rate. If you’re in the 28% tax bracket, you’ll pay a 28% tax on short-term capital gains. If you hold the property for 12 months, then you qualify for more favorable long-term capital gains. Depending on your marginal income tax bracket, these taxes could range from 0% to 15%. The IRS takes a smaller cut out of long-term gains than out of ordinary income or short-term gains.
Calculating capital gains
You pay capital gains tax on the difference between your selling price in the property and your adjusted tax basis. Your adjusted tax basis is the original cost you paid for the property, plus any amount invested in renovations (including labor costs) that you have not previously deducted for taxes.
If you have deductions associated with the property, you subtract them from your tax basis. If your adjusted tax basis is higher than your sale, you have a capital loss. You can subtract capital losses from a given year from capital gains to reduce your tax bill. If you have more capital losses than capital gains, you can “carry forward” these capital losses into future years to offset future capital gains. If you have no capital gains, you can deduct $3,000 annually until you have recognized all your capital loss carry forward.
How to defer capital gains taxes: an intro to like-kind exchanges
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. You cannot swap your rental property for a personal residence, or vice versa.
Depreciation and amortization
When you buy an investment property, the IRS knows it will decrease in value over time. Depreciation is the process of claiming a deduction to compensate you for the property’s decrease in value during the year.
Land doesn’t depreciate, but minerals underneath do. If you are extracting minerals from the land, then 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, the IRS knows you will be using that property to generate income for a long time to come. In certain circumstances, 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 real estate, you must spread the deduction out over 27.5 years.
Passive activity rules
If you are a passive investor — meaning you are not working day-to-day managing your real estate investments — you are subject to passive activity rules. 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. Most individual investor landlords can deduct up to $25,000 per year in losses on rental properties, if necessary (subject to income limitation).
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
Watch for opportunities to take deductions for these common real estate investment expenses:
- Mortgage interest
- Legal fees related to your investment properties or business
- Business use of your home (the home office deduction)
- Advertising fees
Article originally appeared on Zillow.