The U.S. tax code can be quite complex in many areas, and real estate is certainly one of them. For one thing, you may have to worry about paying taxes when you sell a property, but the tax treatment depends on the nature of the property, how long you held it for, and a few other factors. For investors, rental income taxation can also be rather complex, as can several other areas of real estate taxation.
With that in mind, here’s an overview of what all homeowners and real estate investors should know about real estate taxes before buying or selling their next property.
Capital gains taxes: A primer for real estate owners
Before we get into the taxation of different types of real estate sales, it’s important to understand what capital gains tax is and how it works. Here’s a quick overview:
Whenever you sell an asset for more than you paid for it, the profit is known as a capital gain. For example, if you spend $100 to buy a share of stock and you sell it for $120, the $20 profit is a capital gain.
Capital gains are a taxable form of income, but not all capital gains are treated the same when it comes to taxes. In addition to certain exemptions, one of which we’ll get into in the next section, capital gains are broken down into two categories -- long-term and short-term.
Short-term capital gains occur when you sell an asset that you’ve owned for one year or less. For example, if you buy a stock and sell it for a profit after three months, it will be considered a short-term capital gain. Short-term gains are taxed as ordinary income -- in other words, if your marginal tax rate (tax bracket) is 22% for the 2019 tax year, your short-term capital gains are also taxable at that rate.
On the other hand, if you owned the asset for more than one year, a profitable sale will result in a long-term capital gain. The U.S. tax code is set up to encourage long-term investment, so long-term gains are taxed at lower rates than short-term gains. The income thresholds change annually with inflation, but here’s a chart of the long-term capital gains tax brackets for 2019:
|Long-Term Capital Gains Tax Rate||Single Filers (taxable income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|0%||$0 - $39,375||$0 - $78,750||$0 - $52,750||$0 - $39,375|
|15%||$39,376 - $434,550||$78,751 - $488,850||$0 - $461,700||$39,376 - $244,425|
|20%||Over $434,550||Over $488,850||Over $461,700||Over $244,425|
Finally, it’s important to note that higher-income individuals have to pay an additional 3.8% tax on their net investment income. This is applied to both long-term and short-term gains for individuals whose income exceeds certain thresholds.
Cost basis: What real estate owners need to know
Another important concept to understand before we dive into real estate taxation is cost basis.
If you buy a property for $100,000 and sell it for $130,000, you don’t necessarily have a $30,000 capital gain. Your gain is defined as the sale price after all expenses related to the sale, minus your cost basis, which is the price you paid for the asset plus any acquisition expenses.
As a simplified example, let’s say that you bought a property for $100,000 and paid $5,000 in various legal fees and other acquisition expenses. Then, you sell it a few years later for $130,000, and pay $6,000 in real estate commissions and other selling costs. Your capital gain would be the net proceeds from the sale, or $124,000, minus your total cost basis, or $105,000. So instead of a $30,000 capital gain, you’d have a $19,000 gain for tax purposes.
A couple more notes on cost basis:
- If you inherit an asset, the cost basis is reset to the fair market value at the time of the original owner’s death. If your parent paid $10 per share for a stock investment that is worth $80 at the time of death, the latter number would be your new cost basis (this concept is known as step-up in basis).
- If you make substantial value-adding improvements to a property, they can add to your cost basis. In other words, if you buy a property for $200,000 and spend $50,000 on a major kitchen and bathroom renovation, your cost basis could be the total of the two. However, maintenance expenses and repair costs are generally not considered to be part of the cost basis.
Taxes on the sale of your main home
If you sell your home at a profit, you probably don’t need to worry about paying capital gains tax on the sale unless you sell the home for a lot more than you paid for it.
Specifically, there’s a capital gains tax exclusion for the sale of your main home. Known as the primary residence exclusion, this allows home sellers to exclude as much as $250,000 of capital gains from the sale of a main home (but not a vacation home or investment property). Married couples who file joint tax returns can use the exclusion for each spouse, meaning that as much as $500,000 in profit from the sale of a primary residence can be excluded from income.
In order to qualify for the exclusion, there are two conditions that must be met:
- You must have owned the home for at least two out of the five years before the sale.
- You must have used the home as your main home for at least two of the five years before the sale.
It’s important to mention that these don’t necessarily need to happen at the same time. As an example, if you had lived in a home for two years while paying rent, but then you purchased the home and sold it two years later, it could qualify. You also cannot use the primary residence exclusion if you used it to exclude a gain from another home during the two-year period before the sale took place.
Selling an investment property can be a little more complicated
Obviously, the primary residence exclusion doesn’t apply to investment properties, but these can have significantly more complex tax situations when you sell. There are two types of tax you might need to pay on the sale of an investment property -- capital gains tax and depreciation recapture.
Capital gains tax
We’ve already looked at an overview of how capital gains tax works, so this is the easier part to explain. Simply put, there is no exclusion for capital gains on an investment property like there is for a primary residence.
When you sell an investment property, your net profit is subject to capital gains tax. If you owned the property for over a year, you’ll pay the lower long-term capital gains tax rates, and if you owned it for one year or less, your profits will be taxed as ordinary income.
Here’s where investment property taxation gets a little more complicated. One of the biggest tax benefits of investing in real estate (from an income perspective) is the ability to deduct the property’s depreciation each year.
Think of depreciation as a business tax write-off, except that it happens gradually over a period of years instead of being taken all at once. For example, if you buy a piece of business equipment for $20,000 with a useful lifespan of five years, you could deduct one-fifth of its cost each year for five years (the depreciation rules for business assets can be far more complicated, but you get the idea).
Real estate held for investment can also be depreciated over time. The "useful life span" for real estate is defined by the IRS as 27.5 years for residential property and 39 years for commercial property. In other words, you can divide your cost basis by the appropriate lifespan and deduct this amount every year until the entire cost basis has been deducted.
For example, if you acquire a residential investment property with a cost basis of $200,000, you can take a depreciation deduction of $7,273 each year, which can be used to lower your taxable rental income (more on that later).
During the year you buy the property and the year you sell it, your depreciation expense is prorated based on the month in which you buy (or sell) the property. And you must stop claiming a depreciation expense after your cumulative depreciation expense adds up to your cost basis in the building. If your cost basis in an investment property is $200,000, the total depreciation you claim over time cannot exceed this amount.
The downside is that when you sell the investment property, the IRS wants this tax benefit repaid. So if you claimed $40,000 in depreciation while you owned an investment property, you’ll have an additional $40,000 in taxable income upon the sale of the property, in addition to any capital gain. What’s more, because depreciation is used to offset rental income (a form of ordinary income), depreciation recapture is taxed as ordinary income, not at the favorable long-term capital gains rates.
An example of an investment property sale
To put this together, let’s say that you own an investment property that you purchased for $200,000, inclusive of acquisition costs. After holding the property for five years, you’ve claimed $36,365 in depreciation.
After five years, you sell the property for net proceeds of $250,000. This gives you a capital gain of $50,000 on the sale, which will be taxed at your appropriate long-term capital gains rate. You’ll also owe depreciation recapture on $36,365, which will be taxed at your ordinary income rate.
As you can see, taxes on the sale of an investment property can add up quickly. Fortunately for long-term investors, there is a way to avoid paying both capital gains and depreciation recapture tax on the profitable sale of an investment property.
This is known as a 1031 exchange, which essentially means that if you sell one investment property, but use the proceeds to acquire another, you can defer paying taxes on the sale. There are quite a few rules and caveats of 1031 exchanges, so be sure to check out our 1031 exchange homepage to learn more, but here are some of the key criteria that need to be satisfied for a successful 1031 exchange:
- The exchange must be completed within 180 days. From the date you sell your investment property, you have 45 days to formally identify potential replacement properties, and a total of 180 days to close on the purchase of a new property or properties.
- You can sell more than one property as part of a 1031 exchange, and you can acquire more than one property. The number of properties you sell and acquire doesn’t necessarily need to be the same.
- In order to defer all of your taxes, the replacement property or properties must be acquired for at least as much as the original property sold for. And you’ll need to carry at least as much debt on the replacement property as you had on the property you sold. For example, if you sell a property for $500,000 with a $300,000 mortgage balance, your new property or properties must meet or exceed both of these figures to defer your taxes.
- You can choose to complete a partial 1031 exchange. If you acquire a replacement property for a lower purchase price, or with less debt, than the original property, you simply pay capital gains and depreciation recapture on the difference.
How is rental income taxed?
So far we’ve looked at how you’re taxed on the sale of real estate, but what about if you use your investment properties to generate rental income?
The short answer is that rental income is taxed as ordinary income. If you’re in the 24% tax bracket, that’s how much you’ll pay on your taxable rental income. However, there are two main ways real estate investors can reduce the amount of rental income that is subject to tax.
First, like any business, rental property owners can deduct their expenses. These could include (but aren’t limited to) maintenance costs, insurance, mortgage interest, property management fees, HOA dues, property taxes, and utilities you pay. For example, if your property brings in $15,000 in rental income and has $7,000 in various expenses, this reduces your rental income to $8,000.
Second, as we discussed earlier, you can take an annual depreciation expense on your rental property. Continuing this example, if you paid $120,000 to acquire the property, and it’s residential in nature, you can take a $4,364 annual depreciation expense for 27.5 years. This is used to further reduce your taxable rental income from $8,000 to just $3,636.
In fact, most rental property owners only pay tax on a fraction of their actual rental income. It’s not even uncommon for a rental property to show a loss for tax purposes when the owner actually took in thousands in profit.
How property taxes work
No discussion of real estate taxation would be complete without mentioning property taxes. After all, there are some states with no income tax and others with no state sales tax. However, all states in the U.S. charge property taxes on real estate.
Property taxes are used to pay for a variety of government services. In lots of states, public education is primarily funded through property taxes. Fire and police services, trash collection, and other local services are also commonly funded (at least in part) by real estate property taxes.
It’s difficult to tell you what to expect in property taxes, as they vary dramatically from state to state. The U.S. average homeowner pays 1.18% of their home’s value in annual real estate taxes, but some pay far more while others get a relative bargain. On the high end, the average New Jersey homeowner pays 2.44% of the value of their home every year in real estate property taxes, but on the low end, the average Hawaii homeowner pays just 0.27% of their home’s value.
Investing in real estate through stocks or other means
As a final subject, it’s important to discuss real estate investments that don’t involve directly buying properties. Investors can choose to put their money to work in companies that invest in real estate, either through the stock market or through private or non-listed companies.
There are two potential tax implications in these cases -- taxes you may have to pay on dividends you receive and capital gains taxes you might have to pay when you sell.
Capital gains work in the same general way we’ve discussed in previous sections. If you hold the investment for over a year, capital gains will be taxed at the favorable long-term rates, while if you held the investment for a year or less, profits will be taxed as short-term gains or ordinary income.
Taxation of dividends
Dividend taxes can potentially be more complicated. While dividends are generally considered taxable income, the tax treatment depends on certain things.
Specifically, the classification of the business makes a difference. If your investment is classified as a real estate investment trust, or REIT, the dividends you receive will typically be taxable as ordinary income. REITs are considered to be pass-through entities, so the dividends don’t get favorable tax treatment. It’s possible that some portion of your REIT dividends will get favorable tax treatment, while others can be considered a non-taxable return of capital.
On the other hand, if the company you invest in is not classified as a REIT, you might get favorable tax rates on your dividends. Most non-REIT stock dividends meet the IRS definition of "qualified dividends," which entitle their recipients to the same favorable tax rates that are applied to long-term capital gains.
Fortunately, with stock investments, your broker will keep track of the tax classification of your dividends and will break them down to you when you receive your year-end tax forms. Most non-listed real estate investments, such as private REITs and crowdfunded real estate investments, do the same.
Real estate in retirement accounts
It’s also worth mentioning that if you hold real estate investments like REITs, publicly-traded stocks, or even properties in tax-advantaged retirement accounts, most of the points in this discussion don’t apply to you. (If you’re curious, you can buy physical investment properties in retirement accounts through the self-directed IRA.)
If you own real estate investments in a tax-deferred account, such as a traditional IRA, you won’t owe any taxes until you withdraw money from the account. In these accounts, you generally get a current-year tax deduction for the contributions you make, and you won’t have to worry about dividend or capital gains taxes on a year-to-year basis. The only taxation comes when you withdraw money, as distributions from these accounts are typically considered to be ordinary income taxable at your marginal tax rate.
On the other hand, if you own your REITs or other real estate investments in a Roth IRA or other after-tax account, you don’t get a tax deduction for your contributions, but you do get the same deferral of dividend and capital gains taxes. Plus, any qualified withdrawals are completely tax-free.
When you consider the high dividend taxes that are generally applied to REIT distributions, as well as the high potential for taxation when selling an investment property, it’s no wonder that real estate investments (especially REITs) are often found in retirement accounts.
When in doubt, defer to the professionals
Finally, although I’ve tried to give a pretty comprehensive overview of real estate taxation, there’s no way to cover every possible tax scenario here. Plus, there are some aspects of real estate taxation that admittedly have some grey area.
The point is that if you ever run into a real estate taxation issue (or any other tax issue, for that matter) that you’re unsure about, it’s a smart idea to ask a tax attorney or an experienced and reputable tax professional. Some of the tax issues we’ve looked at tend to be highly scrutinized by the IRS, such as 1031 exchanges for example, so it’s better to pay for a little bit of reliable professional advice than to put yourself at unnecessary risk of a tax audit.