Real Estate Investing – From Passive Income to Capital Gains
Investing in real estate isn’t a new idea. Year after year, people buy homes to flip them, rent them out, or to hold onto them for the long term. The taxation of real estate is something that is different than any other type of investment. This article will discuss in great detail each facet of this industry.
Generally, income from rentals is treated as passive income, but with a twist. Unless you are a real estate professional, your income, or loss is subject to passive activity rules. Generally, a passive activity in a rental activity is an activity in which a taxpayer does not materially participate. In regards to real estate and the material participation rules there are several tests.
1. Do you work more than 500 hours a year in the business?
2. Do you do most of the work?
3. Do you work more than 100 hours, and no one else works more?
4. Do you have several passive activities in which you participate between 100-500 hours per week?
5. Did you materially participate in the activity for any of the 5 out of 10 preceding years?
These are just a few of the tests that you must qualify for to have your rental activity qualify for material participation. Under the material participation guidelines, the losses that you have from the activity are not limited under the passive income rules.
Generally most taxpayer fall under the active participation rules when it comes to rental properties. Active participation guidelines are easier to meet than are material participation guidelines. Generally to qualify under the active participation rules, a taxpayer has to make management decisions in regards to the rental property. If a taxpayer meets the active participation requirements then they can deduct losses up to $25,000.00, if they meet the Adjusted Gross Income (AGI) limitations.
Most tax deductions are pretty simple when it comes to rental properties. Your main deductions are mortgage interest, depreciation, repairs, travel, insurance, and legal fees. The most valuable deduction that you have is depreciation. Depreciation is an accounting term that means that you are recovering the cost of your rental property over a period of time. Residential rentals are recovered over a period of 27 ½ years. Commercial rentals are recovered over 39 years. If you bought a piece of residential property, for $100,000.00 on January 1st your yearly deduction would be $3,636.00 per year.
Typically, rental properties have losses. The theory behind investing in rental properties are that the cash flow is excellent, they typically lose money (on paper anyway), and the investment gains value over time.
Another real estate investment strategy is buying property, fixing the property up, and flipping it for a substantial profit. There are common misconceptions among real estate investors that flip properties. The first misconception is that when a property is sold, an investor can take those gains and invest them into another property, for which they will flip again, tax free. It is important to note that there is some truth to this. There is something called a Section 1031 Exchange. This allows for an investor to take the profits from the sale of their property and invest it in another property tax free. An IRC § 1031 Exchange (Like-Kind Exchange), has very strict rules. One of them is that you can’t touch the money from the sale. Once you constructively receive the money you pay tax. I will go into 1031exchanges in greater detail later in this article.
Another misconception of an investor that flips properties is that they will owe capital gains tax on the sale of the property. In order to qualify for capital gains tax treatment, an investor will have to hold a property for one year, and one day before they sell it. Most investors that flip properties are in and out of the property in a much shorter time frame than one year and one day. Further, capital gains tax treatment would only be applicable to an investor that sells less than a few properties per year. The actual amount of properties sold in a year, is kept secret by the IRS, but a rule of thumb is less than three properties. They would have to be treated as a passive investor. If you fail to pass this test, then you are treated as a dealer. A dealer is in the business of flipping properties, so the income generated from this type of investment is subject to ordinary income tax.
Depending on what you buy the property for, your fix up expenses, and what you sell the property for, the tax could be pretty substantial. The tax liability that an investor can incur could be as high as 35% in 2012. If the investor is deemed a dealer, they could be subject to self-employment tax of 15.3%. This would be in addition to income tax. If you are in a state that has an income tax, you could be looking at more taxes.
The final type of investor is a true passive investor. They will buy a property or two, and hold them for a relatively long period of time. Typically during this time, they rent them. When it comes time to sell the property, they are subject to the lower capital gain rate than are dealers. One strategy that was touched on earlier was an IRC §1031 Exchange. IRC §1031, covers what is known as a like-kind exchange. Using this strategy is fairly complicated.
A true like-kind exchange happens when you exchange one property for another property that is like the property that they are giving up. For example, let’s say that you have a residential house and you are looking to sell it. You find another residential house that is for sale. Instead of selling your property to buy the other property, you simply exchange the title of your property for the title of the other property. Easy as that; the problem is that in the real world that never happens.
The typical §1031 Exchange happens where an investor sells his property. He then takes the proceeds of that sale and rolls it over into a new property that is like kind. How this works is that the investor would hire a company to act as an intermediary. The intermediary would take possession of the proceeds from the sale of the first property. The investor then has 45 days to identify the like kind property, and 180 days to take possession of the property. The property has to be exactly like the property that was given up. For example you can give up a residential home in exchange for another residential home. You couldn’t however give up a residential home for an apartment complex, as these are not like kind. The basis of the new property is; what the basis of the old property was plus any boot (cash) that was used in addition to the rollover proceeds. These exchanges can be very tricky, and you should seek the advice of a competent tax professional before you begin this process. Again, once you touch the money, it is taxable.