William Timlen, CPA provides tax consulting and planning for real estate clients and high net-worth individuals. In the following article, William Timlen discusses how real estate investing can be a lucrative and rewarding way to build wealth and generate passive income, but it’s important to understand how tax code applies to these investments and how to maximize returns and liabilities.
Beginning the real estate investment journey is an exciting time for every newbie investor — the thought of generating interest, income, capital gains, and dividends can be a real pull for many. And while there are certain tax advantages to owning rental properties, the implications are just as important to consider.
William Timlen, CPA says that the tax world can be a murky one. Littered with jargon and vague forms, real estate taxes are particularly complex. Thus, spending time learning how to navigate the IRS field is essential to living out the property investor dream.
Types of Taxes Faced by Real Estate
The types of taxes faced by investors in the field depend on their owner or investor status. Those involved with REITs or RELPs aren’t subject to property taxes, capital gains, or income taxes. But those who own establishments for renting out will be.
Property Tax
William Timlen says that property taxes imposed by local governments help to fund schools, roads, and local services. They’re paid based on the building’s assessed value and vary by city and state.
Real Estate Income Tax
Rental income is deemed passive income, which is subject to regular income taxes. William Timlen, CPA encourages investors to take the material participation test to determine whether it’s truly passive income.
Net Investment Income Tax (NIIT)
Investment income (such as dividends or interest earned via real estate investing) is subject to NIIT, applied at a 3.8% rate according to William Timlen, CPA.
However, not all real estate investors are subject to this tax; it depends on the amount of money individuals make annually from their investments.
Capital Gains
Upon selling a property for more than its cost basis (i.e., the price paid originally plus improvements and minus depreciation), investors make capital gains, which are subject to IRS taxes.
William Timlen says that the rate changes based on its qualification as short- or long-term capital gains. The former comes from selling properties owned for fewer than 12 months, taxed at ordinary income rates. The latter comes from assets owned for more than a year, taxed at a lower rate than standard income.
Business Income Tax
Renting real estate can count as a business. However, William Timlen says that this only applies if the investor offers more than basic services (e.g., a bed and breakfast).
Individual Income Tax
Investors who don’t own the property are subject to interest income taxes at the same rate as standard income.
Different Real Estate Investments = Different Tax Implications
The applicable taxes vary based on the kind of investment and the income type it creates, as per the following:
• Rental Properties
William Timlen, CPA states that individuals who buy properties and rent them out will owe taxes on net rental income, and can reduce their taxable rental income by using expenses for improvements, management, and maintenance.
Rental income is taxed at the same rate as ordinary income, ranging from 10% to 37%, depending on the individual’s total taxable income. Those in the 24% federal income tax bracket should expect to pay 24% on their rental income.
That said, rental losses can fall under passive activity loss rules — quite a complicated set of guidelines. Such regulations limit people’s ability to offset other income with their passive losses.
• REITs
Real Estate Investment Trusts often give investors dividends and capital returns.
Dividends from such investments are taxed at the same rate as standard income, while capital returns aren’t taxable.
• RELPs
Real Estate Limited Partnerships provide investors with capital gains and rental income.
William Timlen, CPA says that while a RELP doesn’t need to pay taxes, it must file Form 1065 to the IRS, reporting all income. The partners then obtain a Schedule K-1 detailing their investment’s net income share.
Tax Advantages for Real Estate Investors
Despite the relatively complex aspects of a few rules and regulations, real estate investors are afforded plenty of tax advantages, including:
- Writing off property insurance, maintenance costs, mortgage interest, and more
- Claiming depreciation on rental properties
- Not paying Social Security or Medicare taxes as rental income isn’t deemed earned income
- 1031 exchanges (swapping investment properties for a similar building and deferring capital gains)
- Pass-through deductions, allowing investors to deduct as much as 20% of QBI on personal taxes
- Deferring taxes with opportunity zones
In Conclusion
William Timlen says that for real estate investors, thoroughly understanding tax implications is the foundation of successful real estate investing and maximizing income.
