Many people and businesses acquire rental properties and commercial real estate for their earnings potential, and as part of an ongoing portfolio strategy. However, as is the case with many ventures, there can be downsides to buying real estate as an investment. One such downside is taxes.
As an owner of investment real estate, you need to keep the following taxes in mind:
- Taxes on rental income
- Taxes on capital gains
However, with some careful planning (and assistance from your trained tax professional), you could reduce taxes on investment property. Or, at the very least, you could defer some of those taxes.
Taxes on Rental Income - While You Own
On the plus side, however, you can deduct expenses associated with your investment property. These deductions can include:
- Property maintenance
- Mortgage interest
- Insurance costs
- Staff payments
- Property taxes
- Professional services
The other way in which you could reduce taxes on your income-producing property is through depreciation. Depreciation is an income tax deduction that allows you to recover the cost of your “placed-in-service” property; in other words, a property that serves as a source of income. For your purposes, depreciation can help you reduce your current taxable income.
Keep in mind, however, that the IRS will want some of that depreciation back when you sell. This process is known as depreciation recapture, and it’s calculated by taking the amount of the depreciation you took during ownership, and multiplied by 25%. This amount will be charged against what you earn from the sale of your investment property.
Speaking of asset disposition . . .
Taxes on Capital Gains - When You Sell
If you’ve been paying any attention to our blogs, you know we mention capital gains taxes a great deal. Capital gains are the difference between the basis of your property, and its sales price. And, depending on how long you owned that asset, those gains will be taxed either at an ordinary income tax rate, or under the capital gains tax rate.
And, if you’ve been paying attention to our blogs, you already know of ways in which you could avoid some of those taxes or, at least, defer payment on them.
Seller carryback financing. Sometimes known as seller financing or installment sale, this process means you’re the one providing financing to the buyer, rather than a third-party lender. This is advantageous for a buyer who might not otherwise qualify for a conventional mortgage. And, from your perspective, it can continue cash flow, while allowing you to spread out capital gains tax payments. One drawback to this strategy, however, is that the buyer could default on the financing.
1031 exchange. The like-kind exchange is another method of deferring capital gains taxes, by allowing you to “exchange” from your current asset (the relinquished property) into real estate of equal or greater value (the replacement property). Many investors have successfully used the 1031 exchange as part of a tax-deferment strategy, but there are caveats. You must abide by the IRS’ very strict deadlines, and you absolutely must employ a Qualified Intermediary to take control of the financial proceeds throughout the process.
The Tax Management Strategy
Taxes could be considered a foregone conclusion if you own investment property. However, with proper care, forethought, and planning, you could reduce and/or defer those taxes, resulting in more money in your bank account. Working with your financial planner or tax advisor can point you in the direction of developing, and maintaining, viable tax strategies, which could fit with your investment goals.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. 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. It should also not be construed as advice, meeting the particular investment needs of any investor. 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. Costs associated with a 1031 transaction may impact investor returns and may outweigh benefits.