Tax Ramifications and Advantages in Real Estate Investing
Real estate investing is a popular financial mechanism to create cash flow and wealth. Real estate provides investors with diversification in their portfolios.
Investors should know the tax ramifications and advantages, like deducting certain cash and non-cash expenses, to offset the rental income. But, these will have different meanings to different investors.
This article will set out the tax implications and the possible benefits that investors must understand and know. The true success of an investment will be from the net cash after tax. When returns are quoted to potential investors, they are often before-tax returns. The net return on any investment depends on the investor’s knowledge of the after-tax ramifications before making the investment.
Key Takeaways
- Real estate investments will generate cash flow through rental income, capital gains, interest, and dividends
- Investing in residential real estate property can reduce taxable income
- Investors can deduct cash and non-cash items, like operating expenses and depreciation, to offset taxable rental income
- A 1031 exchange will defer the reporting of any gain and the taxes owed on it
What are the Taxes Owed on Real Estate Investing?
The answer to this question will depend on how the property is owned. An owner of an investment property can be an individual, a pass-through entity like an LLC or an S-corp, a partner in a limited partnership, or a shareholder in a real estate investment trust (REIT).
Below are the different taxes an investor may be subject to and a brief explanation of each.
1. Property Taxes
State and local governments assess property taxes to fund schools, police, fire, utilities, libraries, and other public services. These assessments are based on the property’s taxable value. Other assessments are not based on value, like bond interest, street lighting, and garbage collection, and are specific to an area or a neighborhood.
The amount paid for property taxes is considered an operating expense and can be used to offset the rental income generated from the property.
2. Net Investment Income Tax (NIIT)
Unearned income derived from interest and dividends can be subject to this additional tax. The rate of 3.8% is applied to certain investment incomes of high-wage earners. The tax application criterion is based on the filing status and the taxpayer’s modified adjusted gross income (MAGI).
3. Real Estate Income Tax
The income generated from rental investments is known as passive income. Although the IRS has specific definitions for passive and ordinary income, the IRS holds that all rental income generated from real estate investments with active participation is considered passive.
Passive income is not subject to the taxes collected for social security and Medicare (FICA).
Often, investors receiving passive income can deduct mortgage interest, depreciation, and other expenses, whereas investors in a REIT or a limited partnership cannot.
4. Capital Gains
A capital gain is the resulting net income when an investment property is sold for more than its cost basis. Over the term of ownership, the cost basis can increase by the amounts paid for capital improvements and the closing costs from the sale. This total is then decreased by the amount of depreciation claimed over the ownership period. This is known as recapture. The lower the cost basis, the higher the gain.
Therefore, the formula to calculate a gain is:
- [(Sale price – closing costs) – (purchase price + capital investments)] – depreciation recapture = capital gain
As of this writing, the tax rate applied to a capital gain is the sliding scale of 0%, 15%, or 20%. The applicable rate is based on the filing status and the MAGI of the taxpayer. There can be instances where a gain is not taxable.
For an investor to take advantage of the lower rates applied to capital gains, the property must be held long-term, or for more than 1 year and 1 day. Otherwise, the gain realized from the sale will be classified as ordinary income. An investor’s individual tax bracket will often result in a higher tax rate.
5. Individual Income Tax
If an investor does not own the property in their name or in a pass-through entity, then the income earned as interest or dividends is known as ordinary income and will be taxed as such.
How are Different Investment Vehicles Taxed?
An “investment vehicle” is a term used for the asset class and the type of investment. Below are the four common investment classes for real estate and an explanation of how the generated income is taxed.
1. Rental Property
The tax benefits of passive income are found in the passive loss rules. The taxable passive income is added to other taxable income. This total falls into an income tax bracket between 10% and 37% as of this writing. The rate associated with the bracket will be the rate applied to the taxable income.
Without getting too far into the weeds of passive income loss rules, let’s simply say that losses from rental investments can increase the cap on passive losses that other investors cannot benefit.
There are two exceptions under the rules for passive income losses specific to real estate.
A. Passive Loss Allowance
For the investor with material participation in managing their investment property, and if their MAGI is less than $100,000, then this investor can deduct up to $25,000 of passive losses against other taxable income. The $25,000 deduction begins to phase out by $1 for every $2 over $100,000 of MAGI. There is no loss allowance if the MAGI is over $150,000.
Under certain conditions, an investor can be found to have material participation in their investment property when the management responsibilities are outsourced.
B. Qualified Real Estate Professionals
The IRS defines a qualified real estate professional as one who spends more than one-half of their working hours in a business or a trade relating to the real estate industry, and who spends more than 750 hours on the business and rentals. The income earned by a qualified real estate professional is ordinary and taxed as such. Since real estate is their profession instead of an investment, these earnings are not passive.
2. Crowdfunding
Investments in crowdfunding are classified into accredited and non-accredited. These classifications affect the way income is taxed.
Accredited investors participate in “equity” deals. These investments create a percentage of ownership in the property. As an owner, these investors receive a share of the profits and any capital gains. These investments can be over a short- or long-term hold period and are taxed appropriately.
A non-accredited investor participates in “debt” deals as a partner in the lending group without any ownership interest. The income generated comes from the interest and fees taxed as ordinary income.
Investors under the crowdfunding vehicle will receive a K-1 showing income and losses during the tax year.
3. Real Estate Limited Partnerships
Investors in a limited partnership can earn rental income and capital gains like an individual owner. The structure of a limited partnership is two-tiered: the general partner takes on the liability and manages the operations, and the limited partners are hands-off owners.
The partners will receive a K-1 generated from Form 1065 filed by the limited partnership. The structure is a pass-through entity where the tax liability falls to the investor level.
4. Real Estate Investment Trusts (REITs)
The income received from investors in a REIT is classified as dividends and/or the return of capital (i.e., the invested amount). The investors are shareholders in the REIT, and the dividends received from the shares are reported on a 1099-DIV. The dividends are a return on the investment and are taxable.
The return of the invested capital is not taxable, but it lowers the investment basis. A lower investment basis will result in a higher gain when the stock is sold.
The dividends earned on the investment are taxed as ordinary income to the investor.
The Tax Advantages of Real Estate Investing
Several tax advantages are offered to real estate investors. These advantages may not apply to all investors, but they are available to all participants in the investment arena. These advantages are listed and explained below.
1. Lower Rates for Long-Term Capital Gains
A gain is realized when an investor sells the property for more than the adjusted basis. This appreciation in the value can be generated from the market and by the equity created when the principal balance of the mortgage is reduced. The favorable tax rate will apply to the gain if the investor owns a property for more than 1 year and 1 day.
2. Depreciation Deduction
When real estate is owned as a business asset or as a third-party rental, the depreciation can also be used to offset the income for that year. Depreciation is the cost of the property over time.
The IRS has depreciation tables for the life cycles of capital assets, and the depreciable values of these assets are deductible.
The life cycle, or the depreciation period, for residential buildings is 27.5 years. For commercial buildings, the life cycle is 39 years.
The land value is subtracted from the purchase price to calculate the depreciable value. A property’s depreciable value pertains only to the improvements. Land does not depreciate.
3. 1031 Exchanges
When an investor exchanges one property for another like-kind property under the 1031 rules, the capital gains are deferred–not forgiven. However, 1031 exchanges are layered and complicated, resulting in substantially higher costs.
In the past when the tax rate for capital gains was higher than the individual income tax rates, 1031 exchanges were prevalent. However, in these days of lower capital gain rates, there are transactions where the fees of a 1031 exchange are more than the tax.
Therefore, 1031 exchanges are not as prevalent in the market, but this could change should Congress increase the capital gains rate.
4. Rental Income is Considered Passive
Earned and unearned incomes are subject to income and FICA taxes. Passive income is only subject to income tax.
While this is not a considerable saving in the scheme of the investment, there can be savings in the thousands of dollars in a tax year.
Conclusion
Income taxes are complicated enough without investment income. It is important for investors to know the effects of taxes. This knowledge will make for productive and efficient conversations with a CPA or a financial advisor.
Every investor should know each investment vehicle’s tax ramifications and benefits. The investment returns should be calculated on an after-tax basis. There will not be an accurate cash-on-cash return if tax liabilities are not considered.
