Taxes are somewhat necessary evils to virtually all of us. If you’re considering becoming a real estate investor, however, taxes might just become your pocket’s best friend.
Tax deductions are a well-known perk of real estate investing. Many operating expenses fall under tax deductibles, which is one of the benefits that makes real estate investing alluring to so many. These tax deductibles, however, aren’t the only aspect of real estate taxes an investor should be aware of. Capital gains tax, depreciation and recapture, and the 1031 Exchange are other important parts of real estate taxation. So, without further ado, here’s the right way to do taxes as a real estate investor.
Reporting Rental Income Tax and Property Tax
Rental income is undoubtedly the largest benefit of real estate investing. However, it is a benefit that needs to be reported in order to file income tax. Reporting income tax is also the first step to obtaining tax deductions.
The second most common form of real estate taxes is the property tax. Property tax differs from location to location. Because of this complication, it’s best to consult a tax advisor when wanting to file property tax, and income tax, for that matter.
Real Estate Taxes Deductions
Any real estate investor will tell you that the bright spot of a 1040 is claiming tax deductibles on rental properties. What exactly falls under tax deductions? Essentially any expenses associated with operating the investment property can be deducted. Common examples include maintenance costs, utilities, association fees, electrical bills, advertising, property and liability insurance, repairs and much more. It’s worth noting that repairs, and not improvements, are considered tax deductible. Tax deductions can also cover some financing costs, such as mortgage interest.
Attempting to add up and track all of these expenses and costs can easily make a real estate investor confused. The best way to stay clear and organized when analyzing expenses is to use a rental property calculator. This is a topic on its own, but we will go over it later in this blog. Still, for more information about the rental property calculator, we recommend you read this: “Investment Property Calculator for Analyzing Real Estate Investments.”
Capital Gains Tax
Operating a rental property isn’t the only real estate investing activity with tax implications. Selling a property raises the same “how to do taxes” questions. One of the major tax implications for a real estate investor selling an investment property is the capital gains tax.
The capital gains tax is a benefit a real estate investor receives when selling an investment property. The tax falls into two categories: short-term capital gains tax and long-term capital gains tax. A house investor doesn’t receive much of break with short-term capital gains taxes. These taxes, which apply for investment properties held for less than a year, can range from 10 to 39% of the sales profit. A long-term capital gains tax, as the name suggests, applies for investment properties owned for over a year. The benefit of this tax is much more obvious, as it can range from 20% of the profit to nothing at all.
Depreciation and Recapture
Another common “how to do taxes” factoid is depreciation and recapture. Let’s start with depreciation. Essentially, it is a deduction based on assets that break down, or depreciate, over time. In this case, the investment property is the asset. The IRS determines the time of depreciation of a residential investment property to be 27.5 years and of commercial investment properties to be 39 years. This means that over an amount of time, a real estate investor receives a deduction worth the value of the rental properties.
Depreciation seems all safe and sound…until you get into recapture. Recapture occurs when a house investor sells real estate investments with depreciation. In this situation, the IRS will recapture the amount a real estate investor has been receiving in depreciation. To be more specific, the IRS will tax a house investor with 25% of the depreciation.
Luckily, a real estate investor could decide to not face recapture on one condition. If the investor sells the current investment property and uses the profit to buy higher priced real estate investments, the depreciation will live on.
The 1031 Exchange is among the best real estate investment strategies for long-term real estate investors. It allows them to defer from paying long-term capital gains tax and continue depreciation. However, there are important rules the investor must follow for a rental property to fall under the 1031 Exchange.
For starters, the real estate investor must close the deal when buying new rental properties within 180 days. The investor must identify real estate investments within 45 days prior to closing the deal. Also, the real estate investor must purchase real estate investments that are similar in type. A commercial property cannot be bought after a residential one. And finally, to assure that the investor uses the sales profit to buy a new property, an intermediate must hold on to the cash profit of the sale.
How to Manage Real Estate Investing Expenses
Perhaps the biggest “how to do taxes” question is how to manage and track all expenses that are deductible. The answer to this complicated question is quite simple. All a real estate investor needs is a rental property calculator.
The rental property calculator has many applications when it comes to any of the real estate investment strategies. When it comes to taxes, the calculator can tell an investor a whole lot. For instance, it calculates all the different expenses associated with a rental property. Even if the property has not been rented yet, it will be able to accurately predict, based on a few inputs, what these values will be. If you want to learn more about how predictive analytics work, read this: “The Use of Predictive Analytics in Real Estate Investing.”
The calculator also details what rental income and depreciation the property will likely have. The investor can use this information for both income tax and depreciation value.
The rental property calculator is a must for any real estate investor, regardless of real estate investment strategies. Mashvisor’s calculator provides all of what was just mentioned, and much more! To learn more about Mashvisor’s other valuable real estate investing tools, read this: “6 Must-Have Real Estate Investment Tools!” To start using these tools, click here to start your 14-day free trial with Mashvisor!