How are real estate investments taxed? What potential investors should know
What types of taxes is real estate subject to?
When dealing in real estate, the kinds of taxes you’ll be subjected to will depend on whether you’re a property owner or simply an investor. For example, if you own a home or condo and rent it out, you’ll pay property taxes to your state or local government, income taxes on the rental income you earn, and capital gains taxes if you later sell the property at a gain.
That’s very different from investing in real estate through crowdfunding, a real estate investment trust (REIT) or a real estate limited partnership (RELP). Without the hassle of actually owning a property, the taxes you’re subjected to are individual income taxes.
Here is an overview of the different types of taxes you might pay when you own or invest in real estate.
Property taxes
State and local governments impose property or real estate taxes annually to help pay for schools, police and fire departments, roads, and other state and local services. Property taxes are usually based on the property’s assessed value, including the land, buildings, and other improvements. Property tax rates vary greatly depending on what city and state you live in.
Net investment income tax (NIIT)
Some types of real estate investing result in investment income, such as interest and dividends. If you’re a high earner and make a lot of money off of your investment income, you will have to pay NIIT, which the IRS applies at a 3.8% rate to certain net investment income. The IRS has outlined on its website who is subject to paying this type of tax, which is based on filing status and modified adjusted gross income (MAGI).
Real estate income tax
When you rent out real estate, the rental income is considered passive income and is taxed as regular income. Just make sure you meet the IRS’s definition of what’s considered passive income, which you can do by taking the material participation test to determine whether you actively participated in a business or if it’s truly passive income.
Business income tax
In some cases, renting out real estate counts as a trade or business. This happens only if you provide more than basic services. For example, you could buy a property and turn it into a bed and breakfast, providing linens and meals for guests.
Capital gains
Selling real estate can also generate capital gains if you sell the property for more than its cost basis. Your cost basis is the price you paid for the property, plus any acquisition expenses and improvements, minus depreciation.
Your tax rate will depend on whether it qualifies as a short- or long-term capital gain.
Short-term capital gains are from selling assets owned for less than a year, which are taxed at ordinary income tax rates. Long-term capital gains are for assets owned for a year or more and are taxed at a lower rate than ordinary income, with rates ranging from 0% to 20%, depending on your total taxable income.
Individual income taxes
If you’re simply an investor and don’t actually own property, any gains earn interest income taxed at the same rate as your other ordinary income.
How different real estate investments are taxed
The taxes you pay on real estate investments depend on the type of investment and the type of income it generates. Here are the four different types of real estate investments and how each are taxed.
1. Rental property
When you purchase a property and rent it out, you’ll owe taxes on your net rental income. This means you’re allowed to reduce your taxable rental income by subtracting expenses for getting the property ready to rent and then managing and maintaining it.
Rental income is taxed at the same rate as other ordinary income, such as wages from a job. Federal income tax rates range from 10% to 37%, depending on your total taxable income. If you’re in the 24% federal income tax bracket, you’ll pay 24% on your taxable rental income.
However, rental losses are subject to the passive activity loss rules, which can be quite complicated. These rules limit your ability to offset other income with passive losses.
There are two exceptions that might allow you to used passive losses to offset other income:
- Passive loss allowance. If your MAGI is less than $100,000, you can deduct up to $25,000 in passive losses against other income. This $25,000 deduction phases out by $1 for every $2 that your MAGI exceeds $100,000. Once your MAGI goes over $150,000, you have no remaining passive loss allowance.
- Qualifying real estate professional. If you qualify as a real estate professional, your rental activities aren’t considered passive income. To qualify, you have to spend more than half of your working time on real estate trades or businesses and spend 750 hours or more on the real property business and rentals.
2. Real estate crowdfunding
In crowdfunded real estate investing, how you’re classified as an investor – non-accredited or accredited – will affect how you’re taxed.
Non-accredited investors participate in “debt deals,” acting only as a lender for other property investors and don’t actually own the property. That type of investment generates interest income taxed at the same rate as your other ordinary income and is reported to the IRS using Form 1099-INT. And if you earn more than $1,500 in interest income, you’ll also have to prepare Schedule B.
Accredited investors participate in “equity deals.” An equity deal gives you shares representing property ownership, and you receive rental income and capital gains. Capital gains may be short-term, in which they’re taxed at ordinary income rates, or long-term and qualify for preferential tax rates.
If you participate in crowdfunding real estate investing, you should receive a K-1 tax form sometime before March 15. This form shows the income or losses from your investment during the prior year and you will use it to complete your individual income tax return.
3. Real estate limited partnerships
With RELPs, you can earn rental income and capital gains as you would if you’d invested in real estate on your own. There are two partners in this type of business relationship: a “general partner” who takes on the liability and a “limited partner” who is a hands-off investor.
A RELP isn’t required to pay taxes, although it’s required to file a Form 1065 to the IRS to report all income to the IRS. The partners then receive a Schedule K-1, showing their share of the investment’s net income. The Schedule K-1 is used to prepare each partners’ individual tax return.
4. Real estate investment trusts
Investing in a REIT typically results in two types of investment returns: dividends and return of capital.
Dividends from a REIT are usually non-qualified dividends, which are taxed the same as ordinary income. A return of capital is not taxable income, but it reduces your basis in the investment, resulting in higher capital gains when you eventually sell your REIT shares.
At the end of the year, you should receive a 1099-DIV showing your dividend income from the REIT.
This article was written by insider@insider.com (Janet Berry-Johnson) from Business Insider and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.
