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Real Estate Tax Strategies

Before you start reading this, please be aware that I am not a tax professional, and you should always consult a tax professional. This is provided as a source of information and should not be construed as actual tax advice.

There are two ways real estate transactions are usually taxed, one is a capital gains tax (when you sell the property) and the other is income tax (rental income on Schedule E of 1040). You can avoid capital gains tax if you are selling your primary home, and you lived in the home for at least two of the last five years. This is a great tax advantage and that is the primary reason why people move every few years, you can exclude capital gains up to $250K for single taxpayer or $500K if you are married filing jointly. Also, on a primary home you can claim a “homestead exemption” that reduces the real estate tax on your primary home.

Rental Income: Rental income is basically the rent you receive minus any deductible expense. You can deduct mortgage interest, maintenance expense, repairs, real estate taxes, Homeowners association dues, landlord insurance expense and lawn care expense. You might have other expense that you can deduct also. Not everything is deductible, if you made an improvement or renovation, you would have to depreciate it. Rental income is different than earned wages and is taxed as supplemental income (you do not pay social security/Medicare taxes on it).

When you buy investment property the property won’t stay new forever, it starts to age. Depreciation is a deduction that you can claim because your property will decrease in value as it ages (Land does not depreciate, only the building).  You can claim the depreciation as an expense on your taxes for your investment home (typically you take price of the investment and divide by 27.5 years to get your depreciation expense per year). You can reduce your rental income by depreciating your investment. This means that even though you did not pay anything out of pocket, you can claim an expense and reduce your tax. Before you get too excited, note that you will have to add back your depreciation to calculate your capital gains when you sell your investment.

If you are not a real estate professional, your rental income or loss is categorized as passive. You cannot offset a passive loss against your regular income, you must offset the passive loss against a passive gain (e.g., sale of stocks).

Capital Gains: If you buy a property for flipping it, and you own the property for less than a year, you will have to pay short-term capital gains, it will be the same rate as your marginal income tax rate. If you hold it for more than a year, you can qualify for long-term capital gain tax rate (approximately 15 per cent). However, if you sell your investment for a profit and use it to by another similar property within sixty days you do not have to pay capital gains tax. This is a 1031 exchange. You can defer paying taxes indefinitely if keep rolling the profit into another property. This is another tax advantage of real estate investment.

If you are holding investment property that had been part of a 1031 Exchange, upon your death, your heirs will get the investment on a stepped-up basis. What that means is the value of the property at the date of your death would pass through your estate to your heirs. Again, refer to a tax consultant for details, but this is one way to create generational wealth. 

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