If it exists, the government can tax it. It’s a simple enough concept, but an important one in determining how much you’ll ultimately take home after the work you put into playing the real estate market. Taxable profit refers to the portion of income made from investments (e.g. selling or renting out a house) from which the state can collect its share. It’s a critical figure, especially for people who rely on their investments as a primary source of income. Moreover, understanding the ways to minimize the impact of taxation can prove very helpful in attaining one’s financial goals.
Taxable Income for Rental Properties
For properties that you rent out, taxable profit is what remains of your total revenue after deducting the cost of maintaining and running your building, interest payments on mortgage, value lost to depreciation, and amortization.
Total revenue, in the case of rental income, refers to all cash received from tenants including rental payments, income from coin-operated laundry, utilities payments, the cost of repairs which the landlord may have organized but were paid for by the tenant, and security deposits not returned to the client at the end of the lease.
You can conceptualize it as the following process:
- Beginning with your total revenue, (Rent, and expenses covered by tenants)
- Deduct operating expenses, (Maintenance, utilities, advertizing, etc.)
- Deduct debt service, (Mortgage interest, insurance, etc.)
- Deduct yearly allocated expenses. (Depreciation, amortization, etc.)
What remains is the sum of money the state can tax.
Income from privately-owned rental properties are taxed as personal income –same as a salary earned working for an employer. Your status (i.e. single, married filing separately, married filing jointly, etc.) and personal income tax bracket will determine your rate.
Taxable Income for Real Estate Sales
The tax on real estate sales differs vastly from the tax regime covering rental property income. Since your profit or loss when selling real estate classifies as either capital gains or losses, capital gains tax and its associated formula and rates apply.
To identify how much of your gross sales revenue is subject to tax, deduct selling expenses, the original price of the property, expenses which made the property more valuable, and finally add claims which are generally understood to lower the value of the property.
- Beginning with gross sales revenue,
- Deduct selling expenses, (Brokerage fee, etc.)
- Deduct original price of property,
- Deduct permanent value-adding expenses, (Renovations, pool installation, etc.)
- Add value-decreasing claims. (Depreciation, theft loss deductions, etc.)
The resulting sum is your capital gains or losses.
From here, you can easily refer to federal and state policies on capital gains tax. It’s important to note, however, the difference between short-term and long-term capital gains. You want to avoid the former, more expensive tax by holding onto investments for longer than a year –long-term capital gains taxes are much more generous and will eat up a smaller portion of your profits, ceteris paribus.
Recapture of Depreciation
Before moving on, it’s important we discuss one particularly glaring tax hazard concerning the sale of real estate: recapture of depreciation.
Simply put, part of your profit from a real estate sale can be subject to a hefty 25% tax to “recapture” deductions made due to depreciation –regardless of whether those deductions were actually filed or not.
For example, let’s say you purchased a house at $100,000, which depreciated at a rate of $2,900 per year over the course of ten years. On the tenth year, you decide to sell, and at this point the house had depreciated a total of $29,000. If you were able to sell the house at a gain of $40,000, you’d have to pay a 25% recapture tax on the $29,000 depreciation on top of capital gains tax incurred.
There are ways to minimize and even avoid the significant cost of recapture, but for now it’s enough that you’re aware of it.
It’s interesting to note that while the government is expansive in its coverage of what counts as taxable, exemptions do exist that can ease the financial burden of taxation. These kinds or portions of income are generally referred to as non-taxable, and are prized cash flow components for the financially adept.
The following are two notable forms of non-taxable income for real-estate investors:
a. Capital Loss Deductions
If one or more of your major investments –say, the sale of a house– goes bust, not all is lost. If you lose money on the sale of a long- or short-term investment, the amount lost (i.e. a negative sum of your taxable income computation) can be deducted from your personal income up to a limit of $3,000.
You can deduct the whole value in a single tax year, or spread it out across years until the loss is fully deducted.
b. Deductions on the Sale of a Personal Residence
If you’ve made a house your personal residence for at least two of the last five years from the date of sale, you can enjoy significant deductions to your capital gains tax. As far as the federal government is concerned, this is enough to qualify the home as its owner’s principal residence.
Single owners can exclude up to a quarter of a million dollars ($250,000) from their capital gains tax, while married owners can exclude a half-million ($500,000).
While this wouldn’t apply to the sale of rental or business property, it makes the housing market much friendlier to investors who don’t mind regular changes of scenery –such as those in retirement, or people who work from home. Moreover, serious investors can rent the property out for up to three years and still claim the partial exemption, so long as they’re mindful of the strict technicalities behind the hack.
On a closing note, paying taxes is a matter of civic duty. In more ways than we care to realize, the system looks after us by enforcing our deals, protecting our investments, and cultivating an environment that makes individual enterprise possible.
If you want to beat the IRS at its own game, make sure that your methods are both legal and ethical, and remember that good governance is only possible through the cooperation of the governed.