Basics of Real Estate Property Taxation
“If you’re going to invest in stocks for the long term, or real estate, of course, there are going to be periods when there’s a lot of agony and other periods when there’s a boom. I think you just have to learn to live through them.”
Real estate sounds sexy in conversation but is work in practice.
Knowing the tax implications from purchase, rental, to sale allows you to maximize your return and minimize risk and taxation.
Consider a house that you buy, use as a rental, then sell at a later date.
What are the tax implications throughout the property's useful life?
If you’re not in the business of buying/selling real estate, you’ll file schedule E to report total rental estate estate income.
Or -
If you’re a real estate professional, then you will file schedule C which would report profit/loss from business income.
Many love rental real estate because you have a physical asset that produces cash flow and many ways to write off that income with deductions made available.
On schedule E, total deductible expenses are noted from line 5 through 19:
When it comes to deductions, it’s important to note:
Repairs receive a tax deduction.
Improvement’s do not receive a tax deduction (they increase your basis).
Replacing a screen door, repairing a hole in the wall, fixing a leaky roof, etc. is a deductible real estate expense because it’s a repair not an improvement.
For repairs to be deductible the property must be in service, meaning, the property must be either available for rent (& marketed as such) or currently rented.
Improvements to the property like adding a new deck and upgrading the kitchen add to your basis (& are not deductible).
Basis = what you paid for the property.
This will come in handy later when you look to sell the property (more on this later).
Line 18 - deprecation, is a special deduction that real estate investors can take advantage of.
Depreciation is simply the reduction in the value of an asset with the passage of time.
This is particularly due to wear and tear.
Over time, your home will need repairs.
You’ll need to replace the roof, AC/heating unit, garage door, leaky faucets, etc. these are maintenance costs associated with owning a home.
Note, you cannot depreicate land because land doesn't lose function over time.
Different assets have different useful lives, or, the time period you can depreciate property.
For residential real estate, the useful life is 27.5 years which means you can depreciate 3.63% of the property each year.
If you buy a property for $400,000, of which land costs $115,000 this means we can depreciate the property of $285,000 or $10,363.63 in depreciation for 27.5 years.
The depreciation that you take each year, while it sounds great, it’s not a freebie - it’s recapture upon sale.
After all expenses are deducted against your rental income, you either will have a profit or loss.
If you have a gain, that gain is reported on line 5 of your schedule 1 reporting additional income and adjustments to income. Line 26 which reports total adjustments to income is then finally reported on line 10 of your 1040.
If you report a loss - things are a bit more tricky.
With real estate, there are three classifications which determine how you can write off the loss:
Passive
Active
Real Estate Professional
Passive real estate losses can only be deducted against passive real estate income.
Active real estate losses can only be deducted up to $25,000.
This is a special allowance from the IRS, IF you have modified adjusted gross income (MAGI) less than $150,000 (phaseout begins at $100,000).
NOTE: If you make too much money to claim the $25,000 of loss, you can keep note of your activity in the property, then when you sell at a later date, you can realize the $25,000 loss.
To be classified as active you must be making active decisions and own more than 10% in the property.
If you’re a real estate professional then you can take all losses against your W-2 income.
To be classified as a real estate professional, you must materially participate by performing more than 750 hours of real estate services during the year and more than half of your personal services performed in all trades or businesses during the tax year were performed in real estate.
Tax Tip: If your spouse qualifies as an active real estate investor, then you both qualify.
So what happens if you sell the property?
Using our example above, if you bought the property for $400,000, held it for 10 years as a rental property, then sold it - what how much tax will you pay on the sale?
There’s three main items of consideration here:
Long or short term capital gains
Calculating adjusted basis
Depreciation recapture
The sale of your rental property will either be taxed at short term or long term capital gains rates.
Held longer than 12 months = long term capital gains
Held shorter than 12 months = short term capital gains
Cost basis is what we purchased the property for.
If you bought the property for $400,000, there are a few things that can increases basis, such as:
Legal fees
Recording fees
Transfer tax
Real estate commissions (both when you buy and sell)
Title insurance
Improvements to the property (ex: property additions, roof/driveway/HVAC replacement, property rewiring, etc.)
Note, this is not repairs, as those are deductible in the year the repair is done.
If all these costs add up to $60,000 you can add this to the purchase price to the property making basis $460,000.
Let’s look at this more closely:
Sale Price = $600,000
Original Basis = $460,000 (improvements and closing costs)
(+) Closing costs = $30,000 (to sell the property)
(-) Depreciation = $103,636.30
(-) Adjusted Basis = $386,363.70
Taxable Gain = $213,636.30
Depreciation is deducted because it is taxed separately - it’s captured upon sale.
Deprecation is not taxed as a gain, instead, the amount of depreciation attributable to the gain is taxed as ordinary income up to 25%.
You may be thinking:
“If depreciation is taxed at a higher rate than capital gains, can I just not take depreciation?”
Sadly, no.
Even if you didn’t take the depreciation deductions along the way, you will have to claim the deduction as if you did. There isn’t a reason why you wouldn’t depreciate the property each year.
Continuing with this example, you would have $103,636.30 taxed as ordinary income (up to 25% from depreciation recapture) and $109,727 taxed as capital gain.
Looking at the tax brackets above, let’s assume you’re a married individual with $500k of income and capital gains (including this sale) which will make your tax rate 15% equating to $16,459.05
Capital gains stack on top of ordinary income so odds are high that you’ll pay 15% on the entire $109,727 of gain resulting in federal tax of $16,459.05 in taxes.
But there’s one last kick the IRS gives:
Net Investment Income Tax
This includes income from interest, dividends, capital gains, rents and royalty income, and non-qualified annuities.
This is a 3.8% tax is assessed on the lessor of:
Net investment income
Amount your MAGI exceeds statutory threshold amount
Statutory threshold amounts are:
Married filing joint = $250,000
Married filing separate = $125,000
Single = $200,000
Qualified Widower with child = $250,0000
This this case, your $109,727 capital gain is taxed again at 3.8% or $4,169.62
This makes your total tax due from the sale from your real estate:
Depreciation recapture: $25,909.08
Capital gains: $16,459.05
Net investment income tax: $4,169.62
Total tax due = $46,537.75
There are few certainties in life.
Taxes are one of them!