How to Create a Sound Tax Strategy for Real Estate Investors: Part I
Real estate investment is always aligned with some risks as every investment strategy is carefully crafted using different elements in various proportions. The important bit is to learn how to manage those risks and build a strategy that will withstand the pressure of time (depreciation), overall economic picture (possible inflation) and taxation. Here’s what you need to take into consideration when measuring your real estate investment risks.
Deduction of Expenses
According to the IRS rules, a real estate investor is eligible to deduct the following “ordinary and necessary expenses paid or incurred during the taxable year” in their annual return:
- In carrying out business or trade activities
- To produce or receive income
- To manage, preserve and maintain the property that provides the income
- In relation to the determination, collection, or refund of tax even if the expenses exceed the profit.
Qualifying as Trade or Business
As a real estate owner who rents out their property, your activity can qualify as a business even if:
- This is your only property
- You are actively engaged in another profession or trade
- You outsource the management of the property to an agent
- You experience losses for an interrupted period of several years.
However, there’s a catch. If your activities are minimal and you own a single property, from which you receive income, this won’t be considered a trade. It is not possible to completely avoid tax if this is your situation as what you owe to the IRS will only be deferred. The good news is, this setback can be avoided with careful planning and good investment strategy that will defeat the impact of a “phantom income”.
Depreciation
If you have invested in a property, previously used for business or income generating residence, you can deduct a certain amount for depreciation of the property. Your equity share does not limit the deduction, but other conditions might. Also, take note that long-term capital gains can be taxed at rates higher than 15% in any of the following 3 exceptions:
- Any unrecaptured gain generated from the sale of section 1250 real estate property is taxed at a minimum 25% rate.
- Net capital gains from the sale of collectible items, such as art pieces or coins are taxed at a minimum 28% rate.
- The taxable part of gain, generated from the sale of 1202 qualified small business stock is taxed at a minimum of 28% rate.
Additional Net Investment Income Tax
Since 2013 individuals, trusts and estates have to pay a 3.8% net investment income tax on particular net investment income above the statutory threshold amount.
Read more on managing real estate investment risk and strategies in our future blog posts. Make sure you subscribe so you never miss an update.
Are you thinking of investing in real estate? FAS CPA & Consultants can provide valuable advice on how to begin the process and what tax strategies to use to maximize your profit.
Fulton Abraham Sanchez, the founder of FAS CPA & Consultants of Miami, FL, is a Certified Public Accountant specialized in Tax Planning. You can email him to [email protected].
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