Buying an investment property is a way to diversify your wealth and seek a passive income. Many real estate investors own their primary residence and invest on the side to increase their asset portfolio. However, some investors live in a rental unit while simultaneously investing in rental properties.
If you currently rent your home but are curious about buying an investment property, it is helpful to think about what type of investment property you want to buy, the tax considerations you might face, and what happens if you sell the property.
Whether your investment will be used as a rental property or a second home, this type of alternative investment will have a big impact on the way you file taxes and what will happen if you sell the property.
Primary Residence
A property is considered your primary residence if you intend to live in the property for most of the year and use it to register for voting or on your tax returns. A primary residence is not technically considered an investment property because it isn’t purchased to generate an income. But, for many people, a primary residence is an investment that can bring money through a sale sometime in the future.
Second Home
A second home is a residential property that you buy that you might live in part of the time. This is typically a vacation home in an area where you can rent out the property for part of the year such as on the beach or by a lake. There are various rules that regulate how much time you can live in a second home and what types of renting agreements you can make. As long as you follow these regulations, a second home can be a good investment property.
Rental
A true investment property is purchased in hopes of generating an income. If you are currently renting, you might consider purchasing a rental property to pursue a passive income or in an effort to build your wealth portfolio. Once you purchase a rental property, you have the potential to earn additional income that you can use to pay your current rent, save, or invest in additional properties.
One of the most important tax situations to consider is what happens when you sell your investment property.
When you earn a profit from selling a property, the proceeds are known as capital gains. Until recently, capital gains taxes reached up to 15% to 20% depending on what you earned, however new changes brought on by the American Families Act bring the tax rate up to 39.6% on all income.
When you sell a primary residence, you can reduce the capital gains taxes you owe by meeting the requirements of the IRS eligibility test. On the sale of a rental property, you owe capital gains taxes in most situations.
One option you might have to defer paying taxes on your capital gains of a rental property is a 1031 Exchange. A 1031 Exchange is a transaction that allows you to move your rental properties into “like-kind” assets so that you can hold onto the investment income without paying capital gains. There are four types of 1031 Exchanges to consider, which gives you plenty of options when it’s time to move your assets around.
If you have the cash on hand or access to a reasonable mortgage loan, buying an investment property can be a good idea even while you are renting. A rental investment property can help you start your investment portfolio and earn extra income while renting a less expensive property. Just be aware of the tax specifications and investment strategies that can save you money when you sell.