How Are Real Estate Investments Taxed? What Potential Investors Should Know

You could desire to invest in real estate for a variety of reasons. When a home's value rises over time, it can provide money through appreciation, and if you rent it out, it can generate passive income. Additionally, it's a useful approach to diversifying your stock portfolio.

Tax advantages of real estate investing include the ability to deduct some expenses for rental properties. Real estate taxes, however, may be quite complicated, just like everything else related to the IRS. The tax repercussions of real estate investing are examined below, along with the main tax advantages to keep in mind.

What types of taxes is real estate subject to?
Whether you are a property owner or just an investor, the types of taxes you will be exposed to when dealing in real estate may vary.

That differs greatly from purchasing real estate through a real estate limited partnership, a real estate investment trust (REIT), or a crowdfunding platform (RELP). The taxes that you pay are individual income taxes, which don't require you to deal with the burden of actually owning a home.

Property taxes
Property taxes are levied by state and municipal governments on a yearly basis to help pay for roads, police and fire departments, schools, and other state and local services. Property taxes are typically calculated based on the assessed value of the property, which includes the land, buildings, and other improvements. Depending on the city and state you live in, there are huge variations in property tax rates.

Net investment income tax (NIIT)
Interest and dividends are examples of investment revenue from some real estate investing strategies. If you earn a lot of money from investments and are a high earner, you will have to pay NIIT, which the IRS levies at a rate of 3.8% to certain net investment income. Who is required to pay this kind of tax, which is based on filing status and modified adjusted gross income, as described by the IRS on its website (MAGI).

Real estate income tax
Real estate rental income is regarded as passive income and is subject to ordinary income tax. Take the material participation test to discover whether you actively participated in a business or whether it is actually passive income to ensure that you fit the IRS' definition of what is deemed passive income.

Business income tax
Real estate rental may occasionally be considered a trade or business. This only occurs if you offer services beyond the bare minimum. For instance, you could purchase a home and convert it into a bed and breakfast where you would serve meals and provide linens for visitors.

Capital gains
Selling real estate can also generate capital gains if you sell the property for more than its cost basis and requires real estate accounting. Your cost basis is the price you paid for the property, plus any acquisition expenses and improvements, minus depreciation. 

Tax advantages of real estate investing
Lower rates for long-term capital gains. 
Real estate investors frequently sell a property for more than they purchased for it because real estate tends to increase in value over time. The advantageous tax rates for long-term capital gains are available to you as long as you own the property for more than a year.

1031 exchanges
Real estate investors can exchange an investment property for a property of a similar type while deferring financial gains through a 1031 exchange. Despite the fact that a 1031 exchange can save you thousands of dollars in taxes, these transactions are challenging and subject to several tax regulations. To guarantee it is done correctly, you should always deal with a professional.

Rental income is not earned income
Rental income is exempt from Social Security and Medicare taxes, unlike wages from a job or self-employment income (FICA). Even if this doesn't offer a huge advantage over other forms of investment income, it can nevertheless save you a lot of money when compared to regular earned income. Let's use the example of finding a part-time job where you can make $20,000. FICA taxes on your salary would be $1,530 in your account. On the other hand, there would be no FICA or self-employment taxes associated with a rental property that generated $20,000 in annual income.