There are few investments out there as beneficial as real estate. Known for its tax benefits, streams of income, and property appreciation, buying real estate properties can certainly be a rewarding investment. However, a real estate investor will incur additional taxes which can be very complicated – especially for beginners. As a matter of fact, property investors can have their hands full when it comes to real estate taxes. Don’t worry, though, the following will provide you with the information that every beginner investor needs to better understand real estate taxes associated with owning and investing in properties.
Tax Incurred by Real Estate Investors
First, let’s breakdown the main taxes that you’ll incur as a real estate investor when owning an investment property:
#1 Real Estate Income Tax
Rental income is, undoubtedly, the biggest benefit of investing in real estate rental properties. If you own an investment property that you rent out and collect rent from tenants, you’ll be required to pay taxes on that rental income. As a real estate investor, you must report all rental income to the IRS. Doing so is actually the first step to obtaining tax deductions (we explain these in more details below).
To ensure you provide the correct information, you should keep records of your property management. This includes rent checks, financial statements, receipts, etc. Not providing the correct information could result in losing the ability to deduct as much from your taxes as you’d like. Even worse, property investors could face additional real estate taxes and penalties.
Therefore, one of the most important real estate investing tips for beginners is to establish separate bank accounts to create an effective system to maintain records. This enables you to keep your personal funds and investment-related funds separate. In return, this will create a system for observing how your investment property is performing without worrying that the rental income will overlap with other expenses.
#2 Real Estate Property Taxes
The second type of real estate taxes is the property tax. This is an ad-valorem tax, meaning its amount is based on the assessed value of the transaction or the investment property (including land). State and municipal governments calculate and charge property taxes, meaning they differ from one location to another. Moreover, tax rates, types of properties taxed, and the payment schedule of this tax also varies by locality. As such, it’s best for a real estate investor to consult a tax advisor when filing property tax (and income tax, for that matter) to make sure you’re following the applicable tax laws.
In the US housing market, local governments typically use this type of real estate taxes to fund water and sewer improvements, rubbish collection, road construction, provide law enforcement and fire service, public facility maintenance, and other services that benefit the local community-at-large. If you do not pay property taxes, the taxing authority may assign a lien against your investment property. This is why real estate investors should always complete a full review of outstanding liens before buying property.
To start looking for and analyzing the best investment properties in your city and neighborhood of choice, click here.
#3 Capital Gains Tax (CGT)
Capital gains are simply the profits you’ll make from selling a real estate investment property. As a real estate investor, you have to pay taxes on that profit to the IRS unless you decide to reinvest it into another rental property. Of course, you don’t have to report the total amount of gains you made on your real estate investment – property investors get to offset capital gains with capital losses.
For example, say you’ve bought a rental property for $50,000, put another $20,000 into it to make it suitable for renting, and then sell this property for $100,000. In this case, your profit would be $100,000 minus $70,000 (the purchase price minus the amount you put into the repairs). This leaves you with a gain of $30,000 that you must pay real estate taxes on. The amount of tax property investors pay depends on their tax bracket.
Tax Cuts/Benefits for Real Estate Investors
#1 Tax Deductions
Despite having to pay taxes, one of the most attractive benefits of real estate investing comes in the form of tax deductions. Yes, rental income is taxable, but that doesn’t mean everything you collect from your tenants is taxable. Meaning, when the time comes to file their rental income tax, real estate investors have the ability to deduct costs and expenses associated with operating their investment properties. Deductible expenses that benefit investors when it comes to real estate taxes include:
- Repairs and Improvements: Repairs are work to keep investment properties in an operational and efficient condition such as re-painting the walls, fixing gutters, repairing any leak, etc. Improvements, on the other hand, are work to improve your investment property’s overall value like roof replacement, adding another room, kitchen remodeling, etc. A real estate investor has the ability to write off these expenses during tax time.
- Depreciation: Real estate investors who own rental properties can claim depreciation on newly purchased items. For example, you can deduct depreciation on fixtures and fittings in the income property, such as furniture, blinds, carpets, appliances, hot water system, etc.
- Negative Gearing: Negative gearing happens when the annual costs of your real estate investment are greater than the returns you’re receiving. In simple words, when ongoing costs (like maintenance and mortgage payments) exceed rental income, the rental property is negatively geared. In this case, the government allows you to deduct the loss on your rental property from your gross income, creating a reduction in your tax liability. However, remember that although you’ll pay less tax, this is still a loss. This is why real estate investors always aim to invest in positively geared properties because they allow for cash flow and ultimately a better ROI.
- Travel Expenses: If you own a rental property out-of-state, you can deduct the cost of travel to your real estate investment if the main purpose of the trip is to check on the property or perform tasks related to renting it out.
For more information on real estate taxes and deductions, read: All You Need to Know About Investment Property Tax Deductions
#2 No Tax on Appreciation
As a beginner real estate investor, you must have done your research about what you need to know before you start investing in properties and came across appreciation. This term basically means that real estate goes up in value over the long-run about the same rate as inflation. This is also a great benefit of owning a rental property as it allows for profits when you sell.
As mentioned, you have to pay real estate taxes (the CGT) after selling if you’re not reinvesting the profits. However, one of the most tax-efficient methods to build wealth in real estate is simply not selling. Why? Because real estate appreciation doesn’t get taxed by the IRS! So, you can grow your net worth with minimal tax exposure through buying investment properties and holding them for years. This is also known as the buy-and-hold investment strategy. And when you do choose to sell, real estate has other benefits to offer.
#3 Opportunity Zones
The “Opportunity Zone” program is perhaps the most innovative and profitable tax law change for real estate investors. To benefit from this program, you must invest in certain areas that are designated as Opportunity Zones through a vehicle called an Opportunity Fund. Here’s how real estate investors benefit from this program:
- Temporary deferral of capital gain tax if you sell a property and reinvest gains in an Opportunity Fund. You’ll pay taxes on the deferred gain either when the opportunity zone investment is sold or December 31, 2026 (whichever comes first).
- A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis increases by 10% if the investment is held for at least 5 years and by an additional 5% if held for at least 7 years. This excludes up to 15% of the original gain from taxation.
- A permanent exclusion of your taxable capital gains from the sale or exchange of the Opportunity Fund investment if it’s held for at least 10 years. For example, if you buy an Opportunity Zone property for $200,000 and sold it over 10 years later for $500,000, you’d pay zero tax on $300,000 of new capital gain!
Want to take advantage of these tax benefits? Discover the 21 Best Opportunity Zones to Invest in Real Estate in the US!
#4 The 1031 Exchange
Another way to avoid paying capital gains tax is the 1031 exchange. Named after section 1031 of the US tax code, this is a way for real estate investors to delay paying taxes when they sell investment properties. The way it works is simple: After selling your property, you use 100% of the profits from the sale and reinvest it in the next property. So basically, the 1031 exchange allows you to trade one real estate property for another without paying real estate taxes. To qualify, however, you must meet the following criteria:
- The Like-Kind Exchange: The new investment property must be of the same character, nature, or class of the previous one. Meaning, you can’t sell a residential property to buy a commercial one. Also, the value of the new property should be equal to or greater than the old property.
- Time-Sensitive Investment: The real estate investor has to identify the next property within 45 days of selling. After that, the investor has 180 days to find a new investment property and close the deal.
- A Qualified Intermediary: You can’t handle the money nor transactions on your own. Instead, you must have an intermediary do so.
Do you have a free Mashvisor account? Use our Property Finder to find lucrative investment properties that match your criteria in a matter of minutes and qualify for a 1031 exchange!
#5 Refinancing
To make money in real estate, most property investors consider selling their investments. As we’ve shown above, this will expose you to real estate taxes. If you’re looking for another choice to raise cash, consider this: You can simply pull capital out of an investment tax-free by refinancing. If you choose to refinance, you’re basically taking a new mortgage on the existing investment property to lower the rate, change the loan’s terms, or tap into the property’s equity and convert it to cash! You can then reinvest that money into another rental property and grow your real estate business.
Refinancing investment properties comes with two tax benefits. First off, all of the costs are deductible when you refinance. For example, you can write off your loan fees, any legal or title fees, and any mortgage registration taxes that your city, county or state charge. Second, you don’t pay any tax on the cash from the refinance because it’s borrowed. Nonetheless, this technique increases your risk by acquiring new debt. Therefore, we only recommend refinancing as long as the debt is attractive and covered with cash flow.
The Bottom Line
As you can see, there is a lot that goes into real estate taxes for property investors. Keep in mind that you should only use this article as a guide. Mashvisor works to help investors find and analyze investment properties in the US housing market. But we recommend that you contact your financial advisor for advice on matters related to your personal and real estate taxes.
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