Investing in real estate is lucrative and rewarding. As a real estate investor, you enjoy tax benefits, property appreciation, and sometimes multiple streams of income. However, as with every good investment, real estate properties attract additional taxes that may seem complex, especially for beginners. In this article, we will provide you with everything you need to know about taxes when buying real estate. For new investors trying to get into the real estate market, do not worry; it is nothing too technical.
Taxes Associated with Real Estate Investing
If we are being honest, no one likes taxes. Nevertheless, taxes are an important part of the economy. Seasoned real estate investors know taxes are a huge part of the business, and so should you. Underestimating the importance of taxes in real estate can be a costly mistake, which can make you lose your house despite having paid fully for it.
Property taxes are taxes paid by property owners to the local government or municipality. The money collected from property tax goes towards road repair in your area, firefighters, local schools, and local police. In some states, the money also caters for garbage collection and the maintenance of water and sewerage systems. To calculate how much property tax you should pay, you multiply the assessed value of your real estate property by your state’s tax rate.
For example, if the assessed value of your property is $100000 and the property tax rate in the state where the property is located is 5%, then your property tax is $5000 per year.
Each state sets its own tax rate. Therefore, despite the assessed value of two properties in different states being the same, the amount of property tax owed can differ depending on the property tax rates in each state. The assessed value of a real estate property is also calculated and assigned by state officials. The assessed value is not necessarily the property’s market value. It is often lower than the market value, which is a good thing for investors.
It is also important for a real estate investor to stay up to date with assessment values and property tax rates since they change from time to time for various reasons. Failure to pay property tax may force state authorities to assign a lien against your real estate property. When buying real estate, it is important that you review any outstanding lien associated with the property you are eyeing.
Real Estate Income Tax
One of the things that make real estate investing a lucrative venture is rental income. Buying a rental property earns you income in the form of rent from your tenants. However, the Internal Revenue Service (IRS) must also have a piece of the cake. You are required by law to report all rental income to the IRS for taxation purposes. Reporting to the IRS also helps them to calculate the tax deductions you deserve.
When buying real estate, especially rental properties, it is advisable that you open a separate bank account to help you track payments accurately. You should also keep and manage an up to date record to enable you to submit accurate data to the IRS. Some of the things to include in the record are rent checks, receipts of items you bought to enhance the property and financial statements. Submitting incorrect information to the IRS not only reduces the number of tax deductions, but can also attract additional taxes and penalties.
A separate bank account will also help you to separate rental income from personal funds or income from your other investment projects. This is a great way of monitoring the performance of your real estate investment since the income you collect does not overlap with income or expenses other investment ventures.
Capital Gains Tax
Simply put, capital gains are the profit you get after you sell a real estate property. Again, the IRS demands a cut on the profit through the capital gains tax. However, you can avoid paying the capital gains tax by reinvesting the money in a like-kind asset under the 1031 Exchange. For example, if you sell a rental property and buy another one within 180 days, you do not have to pay the capital gains tax. The same principle applies when you sell a home and buy an apartment. Accounting for depreciation and other tax deductions can also reduce the amount of capital gains tax you pay.
After all, deductions are made, your tax bracket determines the amount of capital tax you pay.
Tax Benefits in Real Estate Investing
Real estate investors benefit from several tax deductions because of expenses they might have incurred while operating and managing their real estate investments. Some of the deductible expenses include:
Repairs and Improvements
Repair works include changes made to a real estate property to keep it an operational and efficient state. Some of the repair works considered for deductions include repairing leaks, repainting the walls, fixing the toilets, gutters, and sinks, and so on. Improvement expenses are those intended to improve the overall value of the property, such as kitchen remodeling, adding extra rooms, replacing the roof, and so on. As an investor, you can deduct all these expenses when filing your tax returns.
You enjoy tax benefits on the grounds of depreciation of new items you bought, especially those that break down with time. Such items include electrical appliances, furniture, carpets, hot water system, blinds, and so on.
Sometimes the maintenance and running costs exceed the rental income you receive from your real estate property resulting in negative gearing. In such an instance, the IRS allows you to deduct the loss from your gross income hence reducing your tax liability. However, despite a reduction of your tax liability, negative gearing is bad for business.
The IRS also allows you to deduct travel expenses incurred when you make out-of-state trips to check on your real estate property or to perform tasks related to running the property.
Despite the several taxes associated with real estate investing, it still remains one of the most profitable business ventures. Knowing about these taxes is a mark of a great investor. We hope you have learned everything you need to know about taxes when buying real estate.