RE Tax Basics - AS OF FEBRUARY, 2023 Flashcards
What are the two types of taxation for homeowners?
If you own real estate, you’re on the hook for two primary types of housing-related taxes:
Property taxes(also called real estate taxes).
Capital gains taxes.
How can someone lower his/her home property tax bill?
If you think the assessor made a mistake, you can appeal your home’s assessed value.
You may also be able to lower your tax bill by taking advantage of programs that offer tax deductions and exemptions for
Seniors.
Veterans and their surviving spouses.
People with disabilities.
People who own agricultural land.
Also, most states offer homestead tax breaks that exempt part of your home’s value from property taxes.
One other option: Depending on where you live, you may be eligible for a discount if you pay your tax bill early. Check with your local tax office to learn about any tax deductions, exemptions, and discounts available in your area.
How are capital gains taxes calculated for the sale of a home?
You trigger this tax if the proceeds from selling your property are greater than its cost basis.
Your net proceeds are equal to the price you sold the property for minus any costs associated with the sale. The cost basis is the sum of these elements:
The price you paid for the property.
Costs associated with buying the property (mortgage application fee, appraisal fee, home inspection fees, transfer taxes, etc.).
The cost of any major improvements (replacing the roof, adding a bathroom, etc.).
Capital gains tax applies only to the gain (i.e., the profit) – not the selling price or the net proceeds. To figure out the gain, deduct the cost basis from the net proceeds. If it’s a negative number, you’ve incurred a loss. If it’s a positive number, it’s a gain and you may owe capital gains tax.
What are the rules for capital gains rules for homeowners?
Most homeowners can exclude up to $250,000 ($500,000 if you’re married filing jointly) of capital gains from the sale of their primary home. But to do so:
The house must be your primary residence.
You must have lived in the house for at least two of the last five years (the years don’t have to be consecutive).
You must have owned the house for at least two of the last five years.
Also, you might be able to exclude some of the gains if you sold the house due to:
Job relocation.
Medical or health reasons.
An unforeseen circumstance such as death, divorce, or a natural disaster (and you can no longer afford your current home).
What are the rules for taking advantage of capital gains rates for the sale of a home?
If you have gains that exceed the exclusion or you don’t qualify for one, you’ll report the gain on Schedule D (Form 1040), Capital Gains and Losses. Different tax rates apply depending on how long you owned the property:
It’s a short-term gain if you owned the house for less than a year. These gains are taxed as ordinary income.
It’s a long-term gain if you owned the house for more than a year. These generally receive a more favorable tax rate.
If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax.
What is the net investment income tax?
The net investment income tax is a 3.8% surtax that applies to income from investments. Money you get from interest, dividends, and short-term and long-term capital gains count as investment income subject to the tax. Also included are rental income from real estate, royalty income from intellectual property and property interests in natural resources, and what’s known as passive activity business income. Moreover, if you sell your primary residence and the gain is greater than the $250,000 or $500,000 exemption most taxpayers can use, the excess is treated as taxable investment income.
Because the surtax is on net investment income, you’re allowed to deduct certain expenses that you incur in generating that income. That’s the case even if you typically can’t deduct those expenses directly against investment income for regular tax purposes. Interest expense incurred in making investments, brokerage and investment advisory fees, costs of tax preparation, rental expenses, and state and local income taxes on the investment income are typically only allowed as itemized deductions, but they would allow you to reduce the amount subject to the surtax.
More importantly, only certain high-income taxpayers have to pay the tax. If you’re single and have adjusted gross income of more than $200,000, then the tax applies to investment income to the extent that it pushes you above that limit. The corresponding limit for joint filers is $250,000. For instance, if you’re part of a couple filing jointly and have $240,000 in combined salary income and $20,000 in investment income, then you’ll pay net investment income tax only on the $10,000 by which the total income of $260,000 exceeds the $250,000 threshold limit.
Describe the SALT and mortgage interest deductions for homeowners.
State and local taxes (the SALT deduction). You can deduct up to $10,000 ($5,000 if married filing separately) of combined property taxes and either state and local income taxes or state and local sales taxes.
You can deduct the interest you pay on up to $750,000 ($375,000 if married filing separately) of mortgage debt on a first and/or second home. If you bought the home before Dec. 15, 2017, you can deduct mortgage interest on debt up to $1 million ($500,000 if married filing separately).
What are the three types of taxes paid by real estate investors?
Property Taxes, Real Estate Income Taxes and Capital Gains Taxes.
What are the key facts about property taxes for real estate investors?
Typically, investment property is assessed at its “highest and best use.” In general, that’s the most profitable use of the property. But it also must be legally permissible (e.g., no zoning or deed restrictions that would preclude that use of the property), physically possible, and financially feasible.
That value is multiplied by the local tax rate to determine the amount you owe. The tax rate is usually higher for commercial real estate than it is for residential properties.
Note that some jurisdictions also tax business personal property (i.e., non-real estate property that the business owns). This includes equipment, fixtures, furniture, and other items that help you make money.
If you have an investment somewhere that imposes these taxes, you must file a Business Property Statement (or something similar) each year. After that, an assessor determines the collective value of your personal property and the tax office sends the bill.
How is rental income on investment property taxed?
Rental income is taxed as ordinary income. Your real estate income is everything you earn from rents on the property less any deductible expenses (more on those later). Use Schedule E (Form 1040), Supplemental Income and Loss for reporting.
What are the important facts about capital gains taxes for real estate investors?
. If you sell an investment property for more than you paid for it, you’ll owe capital gains tax. While homeowners can exclude up to $250,000 of the gain ($500,000 if you’re married filing jointly), real estate investors don’t generally qualify for the exclusion because properties aren’t their primary residences.
The sale will trigger short-term capital gains if you held the property for less than a year – for example, if you flipped a house. If you hold it for longer, it’s taxed at the lower, long-term rate (see the above chart for details).
What are the applicable tax deductions for a real estate investor?
If you own an investment property, you can deduct more expenses than you can as a homeowner. In fact, you can deduct all legitimate expenses related to your property, including:
Mortgage interest.
Property taxes.
Insurance.
Operating expenses.
Maintenance and repairs.
Depreciation (Note: this is the subject of other flashcards)
Qualified Business Income (Note: this is the subject of another flashcard)
You claim these deductions during the same year you spend the money and report them (and any rental income) on your Schedule E tax form
Describe the depreciation deduction for real property investors.
You can also deduct the cost of buying and improving the property, but it works differently than other deductions. Rather than taking one huge deduction when you acquire the property, you depreciate the costs across the “useful life” of the property.
According to the IRS, you can depreciate a rental property if it meets four conditions:
You own the property.
You use it in your business or income-producing activity.
The property has a determinable useful life. It must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
The property is expected to last at least one year.
You can’t depreciate a property that you put in service and sell (or remove from service) during the same year. And because land doesn’t wear out, get used up, or become obsolete, you can’t depreciate it. That means you have to figure out the value of the land and subtract it from your cost basis to determine how much you can depreciate.
Any property put into service today will spread depreciation over 27.5 years. That comes out to 3.636% of the cost basis each year.
You continue to depreciate for up to 27.5 years or until you retire the property from service – whichever comes first.
Describe depreciation recapture for real estate investors.
If you sell a rental property, depreciation will play a role in how much tax you owe. That’s because depreciation deductions lower your cost basis in the property, so they ultimately determine your gain or loss when you sell.
The IRS remembers the depreciation deductions you took – and they’ll want some of that money back. That’s what depreciation recapture does. It’s based on your ordinary income tax rate and capped at 25%. It applies to the part of the gain that can be attributed to the depreciation deductions you’ve already taken. You’ll use Form 4797, Sales of Business Property, to report depreciation recapture.
If you sell an investment property for a loss, depreciation recapture won’t apply. As long as you owned the property for at least a year, the loss is considered a Section 1231 loss and you can use it to reduce your tax liability during the tax year.
Alternatively, you can carry back the loss to offset the previous two years of taxable income or carry it forward to offset future income for up to 20 years.
Describe the qualified business income deduction for real estate investors.
Qualified business income on rental property
One other deduction you may be eligible for is the Qualified Business Income (QBI) deduction. This deduction allows pass-through entities to deduct the lesser of these measures:
20% of qualified business income plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
20% of taxable income minus net capital gain.
While it’s easy for many businesses to determine if they qualify for the deduction, it’s been difficult to tell if it applies to rental real estate activities. It hinges on whether rental real estate is considered a trade or business.
IRS Notice 2019-07, however, created a safe harbor for rental real estate – meaning rental property owners can take advantage of the deduction. To qualify, you must spend at least 250 hours a year managing the property and keep records of your activities. Vacation rentals and triple net leases aren’t eligible.
Describe the qualified business income deduction for real estate investors.
Qualified business income on rental property
One other deduction you may be eligible for is the Qualified Business Income (QBI) deduction. This deduction allows pass-through entities to deduct the lesser of these measures:
20% of qualified business income plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
20% of taxable income minus net capital gain.
While it’s easy for many businesses to determine if they qualify for the deduction, it’s been difficult to tell if it applies to rental real estate activities. It hinges on whether rental real estate is considered a trade or business.
IRS Notice 2019-07, however, created a safe harbor for rental real estate – meaning rental property owners can take advantage of the deduction. To qualify, you must spend at least 250 hours a year managing the property and keep records of your activities. Vacation rentals and triple net leases aren’t eligible.
Describe the basics of 1031 exchanges for real estate investors.
These exchanges let you defer paying capital gains taxes when you sell an investment property.
A Section 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. In simple terms, you sell one property and buy another “like-kind” property with the proceeds. In the process, you can avoid paying capital gains tax.
To qualify as a 1031 exchange, you must meet three conditions with the sale:
The replacement must be like-kind. It’s like-kind if it’s real estate that’s held for productive use in a trade or business or as an investment. Your primary residence wouldn’t count.
You must pay tax on any “boot” in the year you make the exchange. Boot refers to the fair market value of non-like-kind cash, benefits, or other property that you receive in an exchange.
You must identify the replacement like-kind property within 45 days of selling the first property and you must acquire it within 180 days.
Although you defer capital gains taxes, you must still report a 1031 exchange on Form 8824, Like-Kind Exchanges.
How are REITs taxed?
Another way to invest in real estate is through real estate investment trusts (REITs). These are specialized companies that let individuals pool their funds to invest in a collection of properties or other real estate assets.
If you own a REIT, you’ll receive a 1099-DIV each year that shows the type and value of dividends you received. There are three types of dividends:
Ordinary income dividends (shown in Box 1). These are usually taxed at your ordinary income tax rate.
Capital gains distributions (shown in Box 2a). These are usually taxed as long-term gains, no matter how long you had money in the REIT.
Return-of-capital payments (shown in Box 3). You don’t pay tax on these dividends because they’re considered a return of your capital.
Describe the rules regarding Opportunity Zones.
Opportunity zones were created by the 2017 Tax Cuts and Jobs Act. They’re intended to spur economic development and create jobs in distressed communities by providing tax benefits to people who invest money into these areas.
There are three tax incentives for investing in a Qualified Opportunity Fund (QOF):
Capital gains deferral. You can defer tax on prior gains if you invest them in a QOF. You can defer until the QOF is sold or exchanged or until Dec. 31, 2026, whichever comes first.
Capital gains reduction. If capital gains are held in a QOF for at least five years, your basis in the original investment increases by 10%. That jumps to 15% if you hold the investment for at least seven years.
Capital gains exclusion. Capital gains from the QOF are tax-free if you hold the QOF for at least 10 years.
