You can maximize the return on your real estate investments by knowing the rules for writing them off on your taxes.
Taxes on rental income
Rental income is taxable as income on your ordinary income tax return, but is not subject to FICA tax.
Income on your rental property includes anything paid to you as rent or royalty, minus any deductible expenses, which include mortgage interest and basic repairs to bring the property to a minimally functional condition. (You cannot deduct additions, renovations or new buildings.)
Capital gains tax
Capital gains tax applies to any net profits you make when you sell your property.
If you sell after owning a property for less than one year, the IRS will assess a short-term capital gains tax equal to the same rate as your marginal income tax rate.
For tax purposes, it is better to wait to sell until you have owned the property for at least 12 months. In such a sale, you pay long-term capital gains tax, with a rate that ranges between 0 percent and 15 percent, depending on your tax bracket.
Capital gains tax is paid on the difference between the selling price of the property and your adjusted tax basis. Adjusted tax basis is equal to the original amount paid for the property plus any investments made to improve the property, as long as those amounts haven’t been previously deducted. When calculating the tax basis, be sure to subtract any deductions related to the property.
If your adjusted tax basis is higher than the amount of the sale, you have a capital loss. The amount of capital gains tax you owe is then reduced by subtracting capital losses from the capital gains tax amount.
Each year, you can use at most $3,000 as a tax write-off against income other than capital gains. When you have more capital losses than capital gains beyond $3,000, you can use the capital losses to offset capital gains in future years. This is called carrying the losses forward.
If you sell an investment property and make a profit, then invest in another property within 60 days, you don’t have to pay capital gains tax. This is called a like-kind exchange under Section 1031 of the Internal Revenue Code.
Depreciation and amortization
The IRS takes into account the fact that your investment property will depreciate in value over time and that you will use the property to bring in more income over time. You are able to take a deduction for the property’s reduction in value over the year.
In most cases, you may amortize your deduction for your investment property over 27.5 years.
Rules for passive activity
A passive investor, who doesn’t work on managing real estate investments day to day, is subject to passive activity rules, which permit deduction of passive losses only to cancel out the gains from passive activities. You cannot use losses from passive activities to offset other capital gains from other property.
Generally, most individual landlords can deduct up to $25,000 per year in losses on rental properties, if needed, subject to an income limitation.
You must pay property taxes each year. You can deduct the property taxes against your rental income, as long as it isn’t a special tax assessment.
An attorney familiar with real estate tax rules can help you make sure you are following all of the rules.