Understanding Capital Gains Tax on a Real Estate Investment Property

Gains Tax on a Real Estate Investment Property

Understanding Capital Gains Tax on a Real Estate Investment Property

Investors earn money from real estate holdings, but taxes affect returns.

Investors who own real estate enjoy a consistent stream of income, but the sale of commercial and residential buildings may result in a hefty tax payment due to capital gains.

Investors should be aware of the different elements that may be able to reduce or even postpone paying capital gains tax on sales of real estate.

According to Michael Underhill, a chief investment officer of Capital Innovations in Pewaukee, Wisconsin, reduced ordinary income tax rates and other beneficial adjustments to the tax brackets for 2018 through 2025 will benefit owners of rental properties.

Owners of rental properties should spend more time and money on tax planning, according to Sarah Hallock, a senior tax manager for the New York-based accounting and tax firm EisnerAmper. Tax law changes have led to increased problems.

The potential tax savings from the 20% deduction for eligible company income and the immediate write-off for qualified upgrades are only two advantages that recent law has given to real estate investors, according to the expert.

On the other hand, leveraged rental activities have been significantly harmed by the cap on business interest expense deductions, according to Hallock.

The temporary lifting of the restriction on interest expensing is provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, she claims.

Impact on Tax Loss Harvesting

The limitations on deductions for losses from passive activities that have been in place since 1986 have affected many real estate investors, according to Hallock.

She explains that rental losses are often considered passive and can only be used to reduce passive income, with any excess losses being carried over to upcoming years.

Investors that focus primarily on real estate are referred to as real estate professionals (REPs). They were not subject to these restrictions.

According to Hallock, recent tax reform under the Tax Cuts and Jobs Act of 2017 imposed new restrictions on taxpayers' ability to write off losses by placing restrictions on the deduction of net operating losses and yearly business losses.

The CARES Act delays the restrictions on loss usage, which provides REPs with some short-term relief in light of the COVID-19 pandemic's effects, the spokesperson said.

Options for Investors

Buying a rental property is by no means the only way for investors to get involved in the real estate market, according to Hallock. According to her, individuals can also invest in eligible opportunity zone funds, private equity funds, and publicly traded real estate investment trusts, or REITs.

Using a 1031 exchange, which derives from Section 1031 of the U.S. Internal Revenue Code, is another strategy that some investors have used.

Bill Golden, a real estate agent with RE/MAX Around Atlanta Realty, who helped a client invest in rental property via a 1031 exchange and has also been an investor and owner himself, says that some real estate investors pick this option to reduce tax liability when they plan to buy multiple properties over time.

If the properties meet the requirements, investors can use the 1031 exchange to defer capital gains when they sell one property and buy another. The investor has no tax liability, or at least less tax liability, at the time of the exchange even though your swaps are taxable if they comply with 1031 standards.

According to Golden, a 1031 technique can be applied numerous times, enabling investors to postpone paying capital gains until they do so at a long-term capital gains rate.

Real estate investors should engage with both a realtor who has some familiarity with them and an attorney who is specifically aware of 1031 exchanges, he advises. "There are a lot of the ins and outs and intricacies to 1031 exchanges," he adds.

According to Golden, investing in rental properties is a "wonderful" short- and long-term plan because the landlord pays well. It may also be difficult and upsetting.

The two factors that determine the return on investment are cash flow and occupancy.

He believes that just because you buy a nice home doesn't guarantee that you'll find a tenant and keep the apartment rented. Recognize that in the current credit market, financial security is a requirement for ownership. Lenders have tightened standards and now want higher down payments and more reserves to account for increased risk.

Contrary to what is commonly believed, Underhill claims that investing in rental properties is the "most active and time-consuming" type of real estate investing you can do. At age 8, he began taking calls for his family's real estate company. Up until the age of 18, Underhill worked there and gained firsthand knowledge of the time and effort required for real estate investing.

According to Adam Salis of Salis Law in Mission Viejo, California, tax rules should never be the deciding factor in a real estate investment.

The fundamentals of sound investment should always be in place; he argues, regardless of the tax advantages. "There are undoubtedly numerous tax benefits from investing in real estate, like interest deductions and depreciation," he says.

Investors should also take into account "the durability of the income stream, the potential for future improvement to the real estate or to that income stream, and, of course, that old adage of location, location, location. Tax laws change over time, but these fundamentals do not change," the author continues.

Where to Seek Advice on Real Estate Investments

Investors should consult with multiple types of experts since real estate deals can be intricate. According to Hallock, a smart accountant would offer more than simply financial reporting and tax compliance.

If your property is in crisis or your family's real estate business is going through growing pains, your accountant might be able to put you in touch with a management expert who can help with debt restructuring, for example, she says. "A seasoned real estate accountant can assist in building your team,"

Salis advises investors to consult with investment and lending brokers for advice. In order to help with property evaluation and due diligence after an investment has been found, a team of experts with the accountant, real estate attorney and other experts should be assembled, according to him.

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