Much like other investment options, real estate investing has tax implications as well. You need to understand these implications before filing your taxes. You don’t need to know everything before you get in the market but definitely before you file taxes. Knowing all the details is very necessary so that you don’t overpay or underpay taxes. You don’t want to be audited for the wrong reasons by IRS. If you don’t feel confident, you can either consult or hire a CPA to maintain your annual taxes. Some investors consult a CPA for at least the first year and then once they feel more comfortable, they start doing their taxes themselves. Of course with the help of software like TurboTax, it is not difficult to file your own taxes because the software automates the process and avoid mistakes. But one thing the software doesn’t do is explain the high level concepts associated with filing real estate related taxes. It is very important to understand the overall scheme of things before you file your first taxes related to your real estate investment.
Different categories of taxable income
At a very high level, what you need to know is that IRS qualifies taxable income in three different categories. The very first category is your earned income i.e. your paycheck and you pay your taxes based on which bracket your income falls into. The second category is your investment income which is basically the income you earn from stocks, mutual funds, bonds, ETFs etc. The third category is called passive income. Real estate income falls into this third category. The difference between investment income and passive income is that you can deduct losses (up to $3000) on investment income from your earned income, however, you cannot deduct loses from passive income from your earned income. Any losses you incur in real estate investment stays in that category. You can however carry your real estate investment losses to next year taxation. This is an essential difference that you need to know upfront before getting into the real estate investment business.
Filing of real estate taxes
You do file a separate form for your passive income related to real estate investment and it is called Schedule E. You will need to fill in details of your investment property, mortgage payments and other expenses related to the real estate property. Needless to say, you need to be organized throughout the year and keep this data current preferable in an accounting software such as QuickBooks.
QuickBooks makes it easier to organize your data in the right buckets and if you keep it updated throughout the year, it makes tax time a piece of cake. In order to utilize QuickBooks fully, it would be better to take a short course on accounting principles as well as study the QuickBooks tutorial well before you input your data. Your data needs to be organized in the right manner so it is readily available at taxation time. Let’s look at different pieces of the puzzle for Schedule E.
Depreciation of property
IRS has set guidelines for depreciation of real estate property for the purposes of taxation. Each real estate property is depreciated over a period of 27.5 years depending on the cost of the structure. Land price is not part of the depreciation. When you purchase a real estate property you need to figure out this amount for tax purposes. There are couple of ways to figure this out, either you go by county appraisal of your property. Or you calculate it from your private appraisal whichever is higher. You want to pick the higher price since this is going to reduce your taxes. You basically reduce the yearly depreciation amount from your rental income. Technically even though you may be cash flow positive on your real estate property, after you deduct the depreciation amount, you may not have to pay taxes at all.
How to calculate
Depreciation amount = Depreciation Basis / Useful Life
Useful life of a residential property is 27.5 years
Amortization
Another concept you need to be aware of as part of real estate tax filing is amortization. This is similar to depreciation but applies to the costs you incurred when applying for a loan for your real estate property. The cost is then divided over the period of the loan and each year you deduct this amount from your real estate income.
How to calculate real estate taxable income
When you are filing taxes on real estate properties, one thing to keep in mind is that you don’t include the principal amount of the mortgage in your expenses. When you are making your mortgage payment, you are paying some amount towards the principal and some as interest. What you subtract from rental income is only the interest portion of your mortgage payment. The formula for figuring out taxable income is as follows:
Annual Rental Income
Less Annual Expenses (Mortgage interest payment, property tax, insurance, any other expense)
Less Depreciation amount
Less Amortization
= Taxable income
Like Exchange
Experts recommend buying property and holding it for a long time. Over time you own the property free and clear and use the income to supplement you retirement. You may also sell your property when your kids are ready to go to college to pay their tuition. If you do want to sell a property, you need to pay taxes on the capital gains and this pretty much washes out the depreciation amount that you had been filing in your taxes. However, there is a way to avoid paying this tax if you purchase another property for a higher price than the property that you are selling. It is called 1031 exchange or Like Exchange. There are certain guidelines for qualifying a property as a like exchange, one of course is the price – the other is that is be a similar type of property in a similar neighborhood. This is common practice to defer paying taxes on your property sale indefinitely.
