Real Estate Investing & Tax Considerations
When evaluating the feasibility of an investment property it is important to have a good understanding of the following tax deductions and fees as short and long term determinants in your analysis.
Operating Expenses incurred in the operation and maintenance of an income producing property are tax deductible. They include such things as accounting fees, advertising costs, legal fees, insurance premiums, janitorial service, lawn maintenance service, leasing commissions, license fees, office supplies and expenses, pest control, property management fees, property taxes, repair costs, salary and wages, snow removal service, misc. supplies, telephone, trash removal, vehicle mileage expenses, utilities, etc.
Mortgage Interest paid on any loan or loans secured by income property is tax deductable, and deducted from rental income, there is no limit to the amount of interest that may be deducted on a rental property. If a rental property owner refinances and pulls cash out, that cash must be spent for a business purpose in order for the interest on it to be deductible.
Points paid on any mortgage or loan secured by an income producing property are deductible over the life of the loan. The term of a loan can differ from the amortization period. For instance, if a purchase loan is amortized over 300 years but has a due date of 10 years; the points paid on this loan would be amortized over 10 years.
Miscellaneous Closing Costs connected with the purchase of an income property such as title and escrow fees, title insurance, appraisal fees, loan application fees and recording fees are deductible in the year of purchase.
Depreciation is the loss in value of an asset / building over time due to wear and tear, physical deterioration and age. The cost of reproducing an income property can be recovered over the useful life of the asset which is determined by law. Depreciation is treated as an expense and is a line item on an income statement. Depreciation can only be applied to the building and not the land, since land does not wear out over time. Residential income property must be depreciated over a 27.5 year period using straight line depreciation. Commercial income property must be depreciated over 39 years using straight line depreciation. Straight line depreciation stipulates that an asset must be depreciated by equal amounts each year over its useful life.
Capital Improvements are subject to the same depreciation method as the depreciation to the building. Capital improvements include a new roof, new siding, a new addition to a building, etc. Capital improvements to a residential income property are depreciated over a 27.5 year period. Capital improvements to a commercial income property are depreciated over 39 years.
Personal Property includes such items as furniture, appliances, lawn maintenance equipment, snow removal equipment, etc. which are not permanently attached to the land or improvements. Depending on the type of property, a recovery period of 5, 7, or 10 should be used. Check with your accountant to determine the appropriate recovery period for a specific type of personal property
Passive Loss, most income from real estate investments is passive income, passive income loss results when all deductions related to a property-operating expenses, mortgage interest, and depreciation-exceed the property's income for the year. Passive loss is determined by combining all income and losses from passive sources for the year. Therefore, a loss from one property can offset income from another.
Passive losses can be used to offset passive income. If a passive loss cannot be fully used in the year it is generated, it can be carried forward to offset passive income in future years. At the time of sale of a property, any unused passive loss from that property may be used to offset the capital gain from the sale.
Passive losses cannot ordinarily be used to offset active or portfolio income. However, up to $25,000 of passive loss can be used if certain conditions are met
- Investor owns 10% or more of the investment
- Investor must actively participate in managing the investment (this does not preclude the use of a professional property management company).
- Investor's adjusted gross income (before applying passive losses) must not excess $100,000 for the full deduction. If income exceeds $100,000, the offset is reduced by $1 for every $2 of income over $100,000
Capital Gains Tax
If you sold an income producing property after May 5, 2003, your gain will be taxed at the following capital gains rates. For income property held more than one year, investors in a 25% or greater marginal tax bracket will be taxed at a 15% long term capital gains rate and a 25% unrecapture depreciation tax rate. For the 2006 and 2007 tax years, investors in a 15% or lower marginal tax bracket will be taxed at a 5% long term capital gains rate and a 15% unrecapture depreciation tax rate. In 2008, 2009 and 2010 the capital gains rate will be lowered from 5% to 0%.
However, if you are in a 15% or lower marginal tax rate, the capital gains that you realize from the sale of an income property is added to your income to determine the capital gains rate that will be applied to your gain. That portion of your gain which is in a 15% tax bracket ( after adding the capital gains amount ) will be taxed at the lower capital gains rate and that portion of your capital gains that is in a 25 % tax bracket ( after adding the capital gains amount ) will be taxed at the 15% capital gains rate.
Un-recapture depreciation taxes is the total of all depreciation taken on the building during the period that you own your income property plus all accumulated depreciation taken on any improvements to the buildings are subject to the un-recapture depreciation tax rates above.
This article is to be used for informational purposes only. The tax laws are complex and ever changing as a potential investor you should consult with an accountant, lawyer, or tax professional before making an investment decision based on tax benefits.
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