Investing in real estate can help make your portfolio more diverse while also giving you opportunities to seek returns and income. If you invest in a property and eventually sell it, your profits may be considered capital gains, which can typically be taxed. However, there is a difference between capital gains that are realized and ones that are unrealized, which you should be aware of before investing in real estate.
What Is a Realized Gain?
A realized loss or profit occurs when you sell an investment at a price that's lower or higher than it was originally purchased for. Let's say that you invest your money into a "fixer-upper" for the purpose of renovating and flipping the property to gain a profit. If the property was initially bought at $150,000 but was sold later on for $225,000 once you renovated it, your realized gain would amount to $75,000 or so.
However, it's also possible for an investment you've made to come with an unrealized gain. When you invest in real estate, any increase in the value of the property from the moment it's purchased is considered an unrealized gain. These profits are entirely theoretical until you've actually sold the property you've invested in.
In the event that the market has a sharp and sudden downturn, what appears to be a gain could quickly turn into a loss, which is why you don't want to count on unrealized gains when attempting to calculate the profits from your investments. Only when a piece of real estate is exchanged or sold at a price that's higher than the initial purchase price does the gain become realized.
Do Realized Gains Count as Income?
Realized gains can be considered long-term or short-term. If the property you invested in was held for less than one year before you sold it again, this would be considered a short-term gain. Anything lengthier than one year would be considered a long-term gain. In most cases, tax rates for long-term gains are lower than those for short-term gains. Regardless of when you sell your investment property, your realized gains will be considered income, which means that they will be taxed.
Short-term capital gains are almost always taxed at standard income rates, which means that the tax you pay can be as high as 37%. On the other hand, long-term gains are meant to be taxed at a lower rate in comparison to standard income rates. The highest tax rate for long-term gains is currently 20%. If your modified adjusted income is above a certain amount, you may be tasked with paying an extra net investment income tax of 3.8% on the capital gains that you bring in.
Even though the realized gains on your investment property will almost certainly be taxed, you may be able to reduce your taxes if the property you sell is your primary residence. If you live in the property for at least two of the past five years, as much as $250,000 of capital gains can be considered tax-free. The non-taxable amount of capital gains increases to $500,000 for married couples.
It's also possible to use capital losses as a means of offsetting capital gains and reducing your tax burden. If you don't use some of your capital losses, these losses can be taken over to the next tax year.
Realized gains are almost always counted as taxable income. However, there are steps you can take to reduce the amount of taxes you owe. If you're using a buy-and-flip strategy with your investment, holding the property for longer than a year before selling it is enough to substantially lower your taxable income.
