Everything You Need to Know About Real Estate Investment Taxes

real estate investment taxes property investor tax

The U.S. tax code is extremely complex. One area where this is especially true is in real estate.

For example, you must worry about paying taxes when selling a property, but the tax treatment is dependent on the nature of the property, how long you have had it, and several other factors.

Tax issues for investors are complex, too. You have to deal with rental income taxation and an array of other issues. When it comes to real estate investment taxes, there are a lot of things you need to know. Learn what these things are here.

A Primer on Capital Gains Taxes for Real Estate Owners

Before diving into how different real estate sales and how they are taxed, you need to understand capital gains tax. This is how it works.  

When you sell an asset for more than what you paid for it, the profit is referred to as a capital gain. For example, if you spent around $100 to purchase a share of stock and you sold it for $150, the $50 profit is considered a capital gain.

Capital gains are taxable income, but not all capital gains will be treated the same when it comes to taxes. Along with some exemptions, capital gains are categorized in one of two ways – short-term and long-term.

Short Term Capital Gains

These occur when you sell assets you have owned for 12 months or less. For example, if you purchase a stock and sell it for a profit after three months, it is considered a short-term capital gain.

These are taxed as ordinary income. For example, if your traditional tax bracket is 22% for the 2019 tax year, then your short-term capital gains will also be taxed at that rate.

Long Term Capital Gains

If you owned an asset for over a year, a profitable sale results in a long-term capital gain. The United States tax code is designed to encourage long-term investments.

This means that long-term gains will be taxed at much lower rates than the short-term gains. Income thresholds will change each year due to inflation, so it is a good idea to find out about this each year.

Understanding Cost Basis for Real Estate Owners

Another concept of real estate taxation you need to understand is cost basis.

If you purchase a property for $100K and sell it for $130K, it doesn’t always mean you have a $30K capital gain. The gain is defined as the sale price after all costs related to the sale, minus your cost basis. This is the price you paid for your asset and any acquisition expenses.

Here is a more straightforward example. You purchased a property for $100K and paid $5K in legal fees and acquisition expenses. You then sell it for $130K a few years later and pay $6K in selling costs and real estate commissions.

The capital gain, in this case, would be the net proceeds from this sale, or $124K minus the total cost basis, or $105K. This means rather than a $30K capital gain; you have a $19K gain for tax documents.

Selling Investment Properties

There are two main types of taxes you may have to pay when you sell an investment property. This includes capital gains tax and depreciation recapture. Learn about both of these here.

Capital Gains Tax

Capital gains tax and how it works was discussed above. Essentially, there isn’t any exclusion for capital gains on investment properties, which is something that is available for your primary residence.

If you sell your investment property, the net profit you earn will be subject to capital gains tax. If you owned the property for more than a year, you would pay the reduced long-term capital gains tax rates, and if you owned it for less than a year, your profits are taxed as ordinary income.

Depreciation Recapture

One of the main tax benefits offered by investing in real estate is the ability you have to deduct the property’s depreciation every year. You can look at depreciation as a business tax write-off, except that it will happen gradually, over time, instead of all at once.

1031 Exchanges

Taxes for investment property sales add up quickly. However, for long-term investors, there is an option for avoiding having to pay both depreciation recapture tax and capital gains tax on the sale of an investment property when you earn a profit.

This is called a 1031 exchange, and it means if you sell an investment property and use the proceeds to purchase another one, you can defer paying the taxes on this sale. It is essential to learn the 1031 exchange identification rules to understand your rights fully.

Remember, this is another part of real estate investing that is quite confusing, so you need to keep this information in mind if you are planning to make a move.

Understanding Real Estate Investment Taxes

When it comes to understanding real estate investment taxes, there are a lot of things to understand. Be sure to keep the information above in mind and, if necessary, work with a professional in the field to ensure you follow the set rules and regulations. This is going to help you receive the most tax benefits for your situation. 

If you are searching for more information about building a successful real estate business, or another business-related topic, be sure to check out some of our other blog posts. Our team is dedicated to helping you find success in any business venture you pursue.