Taxes and your Investment Real Estate

Needless to say, the application of taxes has a profound influence on many areas of our lives. Your investment real estate is similarly affected in a number of ways. For one, a capital gains tax is assessed on the gain from the sale of a capital asset such as real estate. The gain amount is the difference between your adjusted cost basis and the net price at which the property was sold (in other words, the price after sales expenses).

As an example, let's assume that you purchased a property for $450,000 and added $250,000 in capital improvements. You've also depreciated the property $150,000. Your adjusted cost basis would therefore be $550,000 ($450,000 purchase price or basis + $250,000 capital improvements – $150,000 depreciation = $550,000). Going further, let's assume that you sold the property for $900,000 and incurred selling costs of $45,000. Your capital gains would amount to $305,000, and be computed as follows: $900,000 sale price – $45,000 sales expenses – $550,000 adjusted cost basis = $305,000.

If you held the property for one year or less before selling it, the gain is a short-term one and would be taxed as ordinary income. However, if you held it for more than a year, the capital gain would be considered long-term and taxed at a maximum rate of 15 percent. For taxpayers in the lowest tax brackets, long-term capital gains are taxed at 5 percent. (These rates are correct as of this writing; but as always, consult with a competent tax professional for the most up-to-date information.)

If instead of a gain you experience a loss from the sale of your investment property (known as a capital loss), it can be used to offset a capital gain from another property sale. You suffer a loss when your adjusted cost basis is greater than the property's sale price. But if you're going to take a loss on a sale, it's a good idea to make the loss as worthwhile and useful as you possibly can. If you have other property that has appreciated, consider selling it in the same year as you incur your loss – in this manner, your loss will help to shelter your gain.

Many homeowners are aware of the universal tax exclusion for principal residences, in which up to $250,000 of capital gains is exempted from taxation ($500,000 for couples who file jointly). Formerly a one-time-only exclusion for over-55 homeowners, the current version now also offers significant tax benefits to investors that have owned a home and used it as a principal residence in two of the five years preceding the property's sale (the residency time need not run continuously). If the residency requirements are met, the investor will receive the same exclusion from capital gains as a regular homeowner. Likewise, small investors who buy fixer-upper properties can take full advantage of the benefit by simply ensuring that they, too, meet the residency requirement before selling their refurbished property – thereby realizing sizable tax-exempt capital gains that can be used to purchase their next property. The exclusion is also no longer age-restricted and can now be utilized every two years instead of only once.

The exclusion is also available for second- or vacation homes if, during the periods of occupancy, the property is your principal residence. For example, if you lived in your vacation home for five months of each of the previous five years as your principal residence, you would meet the twenty-four-month (two-year) residency requirement.

Because our income tax system is progressive in nature, the tax rate increases with the amount of income earned. It's therefore possible for some taxpayers to keep their income taxes at a lower rate by spreading their profits from the sale of a property over a number of years by using an installment sale. However, this benefit is not available for dealers (those in the business of buying and selling properties) or for total obligations that are greater than $5 million.

Tax-deferred exchanges allow you to take the equity out of a current investment property you own and put it into another investment property without paying taxes on the appreciation in value of the current property. For more information about this type of transaction, please read the article The 1031 Tax Exchange.

Federal, state, and local governments also offer numerous programs and tax incentives to encourage economic and property development in economically distressed areas and to preserve historic structures. A few are listed here:

  • Empowerment Zones - Some cities have been designated by the U.S. Department of Housing and Urban Development (HUD) as Empowerment Zones. This area designation allows the total cost of some improvements to be written off as deductions in the year that they're made rather than requiring the improvements to be depreciated over their usable lifetime. There are also tax incentives for businesses that locate into these zones. Federal employee wage credits may be given for newly hired employees that are residents of the zone. The purpose of such incentives is to make inner-city expansion more attractive to developers and employers.
  • Enterprise Zones – Some states designate economically distressed areas as Enterprise Zones and offer state tax credits and other benefits. In some areas, businesses receive credit for sales tax paid on purchased equipment as well as significant tax credits for each newly hired employee.
  • Community Development aid - Many states and communities encourage economic advancement that will create jobs by offering land at bargain prices, providing low-interest development loans, placing a moratorium on property taxes, and a variety of other methods.
  • Federal historic designation - An investor in a property that holds a national park's designation as a historic place could be entitled to a federal investment tax credit for certified rehabilitation costs. In other words, up to twenty percent of the investor's incurred rehabilitation expenses for the property could be reimbursed as tax credits.
  • Special homeowner property tax benefits - A number of states provide property tax benefits for certain homeowners who reside in their homes, such as veterans, disabled persons, or elderly individuals. These benefits are generally that a portion of the property's value is exempted from taxation. In some states, elderly persons are allowed to defer paying their property taxes until their home is sold or the individual dies, thereby removing the burden from the taxpayer and placing it on his or her estate.

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