Owning an investment property provides another option when seeking to accumulate wealth. Real estate assets have the potential to be a source of income, and property can appreciate. Both methods of earning money are subject to tax assessments.
Taxing Real Estate Income
The IRS considers earnings from rental property passive income in most cases. Exceptions to this determination include property owned by real estate professionals, properties rented out for average stays under seven days, and rentals offered as support for other paid services (such as hospital rooms or student dormitory rooms).
The 2017 Tax Cut and Jobs Act (TCJA) included a provision that established a tax deduction for pass-through business owners known as "the 20% deduction." A pass-through business does not pay corporate taxes; it "passes through" the business's income to the owner, who pays the taxes on a personal return at an individual rate. If the company makes a profit, that is income; if the business has a loss, that is a deduction from other ordinary income the owner earns. These businesses are often small companies and sole proprietorships. The TCJA explicitly includes income earned from rental property.
Since rental income has inherent deductions for expenses that come with the income type, this additional twenty percent is potentially quite valuable to investors. The deduction has a phase-out, and the threshold for 2021 is $164,900 for taxpayers filing with single status and $329,800 if you are married filing jointly. If your income is under that, you can deduct twenty percent of Qualified Business Income, as noted above. The rules for qualifying with income above the threshold depend on the type of business and are complicated.
Gains in the value of real estate are never guaranteed, but they can be frequent. When you own an investment property that rises in value, you must be aware of the potential tax implications if you intend to sell the property. If you sell a real estate asset for more than your cost basis, you will owe taxes on the capital gain. While the tax rate assessed on this gain is less than that applied to ordinary income (assuming that you have held the asset for more than one year), you may still prefer to avoid or defer paying it.
One way to pursue the deferral of capital gains taxes when you want to dispose of a property that has appreciated is to complete a 1031 exchange instead of a direct sale. The transaction takes some advance planning, and you must carefully adhere to the IRS timeline. Still, the procedure offers you the potential to retain the entire appreciated value of the property by exchanging it for a like-kind asset.
An investor can use consecutive 1031 exchanges in an attempt to continue deferring the recognition of capital gains taxes indefinitely by reinvesting the proceeds from each sequential transaction into replacement properties. You can use the process to pursue several portfolio goals, including the following:
- Shift from one asset class or sector to another
- Change or broaden geographic footprint
- Transition from direct investment to fractional
The procedure has risks, and taxpayers must carefully follow the rules governing the process to complete the transaction successfully. However, the potential rewards can be significant. In addition to deferring taxes during an exchange, if the investor bequeaths the exchanged property to an heir, the one-time step-up in cost basis eliminates any taxation of the deferred gain.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.