If you are looking to make a quick buck flipping or renting houses, you need to learn about the tax implications. Why? Because understanding how real estate taxes work will help you maximize your earnings. There are several different types of taxes involved in real estate investing that we’re going to take a look at in this post. Let’s get started!
Understanding Capital Gains & Losses:
A capital gains tax is a tax you incur if you sell an asset for more money than you spent to purchase it. The tax applies to both investments, like stocks and bonds, and personal property. As an example, if you purchase a used car for $3,000 and turn around and sell it for $5,000 a few weeks later, that’s considered a $2,000 capital gain. In the same example, if you sold the used car for $2,000, that’s considered a $1,000 capital loss.
Capital Gains & Losses Can Offset One & Other
Investors know full well that with market fluctuations come profit and loss – and those profits and losses can balance each other out. That’s why it’s important to build a well-balanced real estate investment portfolio that can help you counterbalance riskier investments with more stable income generators.
For example, if you end up down $50k on one property and up $80k on another, you may be able to subtract your loss from your profit, meaning you only have to pay capital gains tax on that remaining $40k. There are also circumstances when you can carry losses over into future tax years to help offset future profits.
Fully understanding how the system works and the tax implications of owning multiple properties, REITs and so on is absolutely critical in helping you build a smart strategy for long-term success. We recommend you hire a financial advisor who is well versed in real estate investments and transactions to talk you through the details.
The Difference Between Long & Short Term Capital Gains:
A short-term capital gain will be applied to any asset that you sell that you’ve owned for a year or less. If you own that same property for a year or more, the sale will be qualified as a long-term capital gain . As you may have already suspected, the short-term capital gains rate is significantly higher (as much as 10-30%) than the long-term rate. That means you’re going to lose more money to taxes when you sell than you would if you held onto the property for a year or more. That’s why buy-and-hold investors incorporate longer ownership timelines into their strategy.
Primary Residences Have Different Rules Than Investment Properties:
So doesn’t that mean all homeowners also have to pay capital gains tax? No, because a piece of property is considered exempt from capital gains tax if it meets these three conditions:
1. You owned your home for at least 2 years during the 5-year time span leading up to your home sale.
2. You used your home as your primary residence for at least two years in that same five-year period.
3. You haven’t sold another capital gains exempt home in two years prior to your current sale.
If you meet all these criteria, you get tax credits for your property. Individuals can claim up to $250k while joint filers can claim up to $500k. But, since you have to meet all of these criteria and can only sell a home that’s exempt once every two years, flippers who move property with any regularity almost never qualify for capital gains exemption. So how do they pay taxes on properties purchased to flip?
Investments Bought & Sold for Business Qualify as Inventory, Not Assets:
All of the above information is valuable if you have intentions of purchasing property as a rental investment. Understanding how capital gains plays into your profits is critical to making sure you’re getting a good deal. But for flippers, the tax implications are quite a bit different, because it’s categorized differently.
Flippers who actively purchase and remodel real estate for profit as a career are classified by the IRS as dealers, not investors. That means properties purchased for this purpose are qualified as inventory, not capital assets. Under these circumstances, the cash made on a sale is treated as income, so flippers investing in inventory properties are required to pay self-employment tax on any profits made.
Knowing the difference between short and long term gains, understanding the variation in tax rates and being aware of tax considerations involved in real estate investments will help you make intelligent financial choices.