For new investors, understanding taxes related to real estate can pose a major challenge. This reality is made even worse by people often talking about the tax advantages of investing in real estate – without actually providing any details. As such, I often hear this question: Ryan, do real estate investors have to pay taxes?
Yes, real estate investors absolutely have to pay taxes. Depending on your strategy, you’ll need to pay different types (e.g. ordinary income, capital gains, etc.). But, real estate also provides outstanding strategies for legally avoiding or deferring taxes, making it a great investment option.
So let’s talk about tax considerations for real estate investors and what you need to know before purchasing your first investment property. Let’s dive in.
Do Real Estate Investors Have to Pay Taxes?
The short answer: yes, real estate investors need to pay a variety of taxes. But, the long answer is that real estate also offers some outstanding strategies for legally avoiding and deferring taxes. I’ll cover both the specific taxes you need to pay and different tax planning tips for minimizing payments no matter your investment strategy.
With that said, here’s the most important item I need to emphasize for new real estate investors. As you begin your investing journey, don’t worry too much about the taxes. Your primary objective as a new investor is to begin making money. Once you start bringing some profits in, you can pay a professional CPA to help you develop your tax planning strategies.
As an investor, you should absolutely have a broad understanding of the information in this article. But, that’s the beauty of making money: you can focus on real estate investing and pay a subject-matter expert to help with your tax planning.
Now that I’ve provided this disclaimer, I need to explain some concepts and definitions related to taxes. To understand real estate tax planning, you need to have a basic grasp of the below items. I will use these definitions and concepts in the remainder of the article to dive into the specifics of taxes for real estate investors.
When investors ask about real estate taxes, they typically mean income taxes. But, I want to emphasize another tax that you will deal with frequently as an investor: property taxes. Whereas states and the federal government impose income taxes on money you earn, local municipalities (e.g. cities, counties, towns, etc.) impose property taxes on the real estate you own.
Here’s how it works. Municipalities have tax assessors on staff. These individuals are responsible for determining the value for tax purposes of every piece of real estate in their municipality. Some areas do these assessments annually, while others may do them every few years. Regardless of frequency, your municipality will determine a value for your property, typically less than market value. And, most municipalities break this value down into A) land value, B) improvement (i.e. structures on the land) value, and C) total value.
Then, towns multiply this total value by the local tax rate to determine your annual property tax bill. For example, assume a home has a tax-assessed value of $200,000 and a local property tax rate of 1.2%. That homeowner would owe annual property taxes of $2,400 ($200,000 x 1.2%), typically collected on a semi-annual or quarterly basis.
Income Tax Rates: Ordinary Income vs. Long-Term Capital Gains
Now, I’ll discuss some income tax concepts that real estate investors should understand but I’m going to focus exclusively on federal income taxes. Not every state imposes income taxes, and the ones that do all have different approaches. Also, tax laws change constantly which is why I advocate for hiring a CPA as soon as you start your REI business.
First, investors need to understand that income, depending on how it’s earned, can be taxed at different rates. Generally speaking, the IRS looks at income as either: 1) ordinary income, or 2) long-term capital gains. Each of these face different tax rates, a fact that can significantly affect your tax bill.
For real estate investors, the money you earn via rental income or in an active real estate business (e.g. regularly flipping houses) will be taxed at ordinary income tax rates. These are also known as your marginal rates, and they currently range from 10% to 37%.
Next, the IRS looks at the income from the sale of a property you’ve owned for more than a year differently. If you sell an investment property that you’ve owned for more than a year, the IRS taxes the profits on your transaction at what’s known as your long-term capital gain rate. Depending on your overall income level, this tax rate varies from 0% to 20%.
For high earners, the differences between ordinary income and long-term capital gains classification can be a huge deal. For instance, a $200,000 profit taxed at the highest ordinary income bracket (37%) creates a $74,000 tax bill. On the other hand, that same profit taxed at the top long-term capital gains rate (20%) leads to a $40,000 tax bill – $34,000 less!
Income Type: Passive vs. Active Income
In addition to different income tax rates, the IRS also considers different income types: active, portfolio, and passive. Portfolio income largely pertains to proceeds from stocks, bonds, and other securities. For real estate investors, active and passive income are the most important to understand.
Active income includes all earned income (e.g. wages, tips, and active business participation). For self-employed individuals, business earnings also qualify as active income. Consequently, if you flip houses as your primary business, the IRS considers that income to be active income. This makes a huge difference in tax treatment, as individuals need to pay self-employment taxes of 15.3% on active income.
On the other hand, passive income includes the income earned from rents, royalties, and limited partnership stakes. This type proves particularly relevant to real estate investors. For most investors, real estate investment income qualifies as passive. This means that, in general, passive losses in real estate can only offset other passive income – not active or portfolio income.
The IRS taxes both active and passive income at your ordinary income tax rate. But, as stated, active income has the unfortunate disadvantage of also being subject to self-employment tax.
Taxes for Fix & Flip Investors
As a fix & flip investor, you’ll need to pay property taxes on your property for the entire period you own that home. However, you gain two advantages. First, due to the distressed nature of these properties, they typically have lower tax-assessed values, so you will face a smaller property tax bill. Second, any property taxes you pay qualify as ordinary expenses that can be deducted from your taxable income.
Income Taxes for Fix & Flip Investors
If you are in the business of flipping houses, that is, this serves as your primary income source, the IRS considers it to be active income. This means that, as you sell houses, the profits will be taxed at your ordinary income rate and subject to self-employment taxes.
From a tax filing perspective, this means that you’ll report this income on Schedule C. But, you’ll also have the advantage of being able to deduct all of your house flipping ordinary business expenses (e.g. office rent, mileage, supplies, payroll, etc.).
Taxes for BRRR Investors
BRRR investors also need to pay property taxes. But, the tax-assessed values of these renovated homes will likely be higher than a distressed property, creating a larger annual tax bill. This tax bill does qualify as an property operating expense, though, meaning that landlords can deduct it from their annual rental income.
Income Taxes for BRRR Investors
The IRS taxes rental income at your ordinary income rate. However, they classify this income as passive, meaning you do not have to pay self-employment tax on it. Additionally, BRRR investors have the advantage of being able to deduct operating expenses (e.g. insurance, property taxes, utilities, property management, etc.) and depreciation expense from this rental income.
With depreciation, investors deduct a portion of an investment property’s purchase price (excluding the portion allocated to land, which isn’t depreciable) every year for a set period of time (27.5 years for residential real estate). As such, depreciation represents a cash-less expense – something that reduces your taxable income without requiring a corresponding cash payment. This often creates a situation with rental properties where they operate with a positive cash flow and a taxable loss.
NOTE: These passive income taxable losses generally can only offset other passive income – not active income. Two exceptions exist to this rule. First, certain investors can deduct up to $25,000 in passive losses against active income. Second, investors classified as real estate professionals can deduct all passive losses against active income.
Long-Term Capital Gains and Depreciation Recapture at Sale
Eventually, BRRR investors sell their rental properties. Assuming they do so after a year of holding them, the profits will be taxed at long-term capital gains rates. However, these investors will also have to pay a tax known as depreciation recapture. Every dollar you deduct via depreciation over the life of your property will be taxed at a 25% depreciation recapture rate.
For instance, if you’ve deducted $100,000 on a property during your ownership, you’ll need to pay a depreciation recapture tax of $25,000 – in addition to the capital gains tax on any proceeds above your original cost basis (normally the purchase price plus rehab costs).
Strategies for Minimizing Taxes as a Real Estate Investor
Now, I want to introduce a few strategies for avoiding or deferring (i.e. delaying) taxes but I will not go in-depth into any of these strategies. Rather, I’ll provide a brief overview of each so you are aware of the options so you can work with a tax professional to develop the best strategy for your unique situation.
Strategy 1: S Corp Election for House Flippers
If you flip houses as a business, that 15.3% self-employment tax can take a huge chunk out your earnings. If you elect that the IRS treat your business as an S Corporation (“S Corp”), you can split your income. That is, you can break your income into two parts: 1) a reasonable salary, and 2) distributions. The salary will be taxed at your ordinary income rate and subject to self-employment taxes, while the distributions will not be subject to self-employment taxes.
Strategy 2: Buy an Owner-Occupied Building
If you need an office as a house flipper, consider purchasing a building in a separate property LLC. Then, you pay that LLC rent from your house flipping business, which reduces your taxable income subject to self-employment tax. As rental income, the property LLC will then receive passive income treatment of this money. If structured properly, you convert active income to passive income, saving on self-employment taxes in the process.
Strategy 3: Use Fix & Flip Proceeds to Buy Rental Properties
Fix & flip investors face two major tax drawbacks: 1) active income treatment, and 2) the inability to depreciate properties. As a result, investors can consider using proceeds from a fix & flip business to eventually buy a portfolio of rental properties, which will generate passive income and offer the benefits of depreciation.
Strategy 4: Section 1031 Like-kind Exchanges
When investors sell a property they’ve held longer than a year, they trigger a capital gains tax and depreciation recapture. However, the IRS offers an opportunity to defer – or delay – these taxes. Using a technique called a Section 1031 Like-kind Exchange, investors can sell one property and roll the taxable basis into another property. This means you don’t need to pay these taxes until you sell that next property (or defer them again by doing another exchange).
NOTE: Section 1031 Exchanges come with strict compliance requirements. If you don’t follow them, you will likely trigger a current tax bill. Be sure to work with a 1031 expert if pursuing this strategy.
Once again, don’t let the above information overwhelm you as a new investor. This article should provide general awareness – it shouldn’t make you a real estate tax expert. Instead, your primary responsibility as a new investor is to start making money! Then, you can pay a professional to help you develop a tax planning strategy.