Capital Gains Tax
The capital gains tax is the levy on the profit that an investor makes when an investment is sold (Investopedia). When you own real estate, or any other asset for that matter, the profit that that asset generates is not considered income, but rather capital gains. This allows investors to pay a lower tax rate than they would have on income, as long as that asset has been held for at least a year. This is called long-term capital gains tax: “The long-term capital gains tax rates for the 2021 and 2022 tax years are 0%, 15%, or 20% of the profit, depending on the income of the filer” (Investopedia). As long as you hold your asset for over a year, you can reap the benefits of long-term capital gains tax rates.
After a property is sold, investors can choose whether or not they want to defer paying the federal capital gains tax by executing a 1031 exchange. After an investor “cashes out” on a property, they can choose to reinvest all the funds into a similar property of equal or greater value. Once an investor chooses to execute a 1031 exchange, they have 45 days to identify a new property, and 180 days to close on said property in order to defer paying capital gains tax.
Depreciation of real estate can be a difficult concept to understand, but when used properly, can save investors from paying taxes on a significant amount of their profits. While land does not depreciate in the long run, the building on that land and the appliances, flooring, and windows, in that building do depreciate. The federal government allows investors of income producing properties to deduct the losses of the depreciation from their income, allowing investors to pay taxes on a smaller portion of their annual rental income. The US government estimates that on average it takes 27.5 years for a property to fully depreciate. This allows investors of income producing real estate to deduct about 3.6% of the cost basis of a property from its annual income every year for 27.5 years. It is important to note that the land the property is on does not depreciate, meaning that the cost basis, for tax purposes, is the value of the property minus the value of the land.
Lets look at an example of using real estate deprecation to lower your taxable income: say an investor purchases a property with a cost basis of $800,000. By dividing the cost basis by 27.5, we get the amount that said investor can deduct from his rental income annually. In this case, the annual deduction would be $29,090 from the investor's taxable income on that rental property. When the property is sold, the amount of depreciation that was deducted is taxed at 25%. This is known as the unrecaptured section 1250 gain. The rest of the profits on the sale are taxed at the federal capital gains tax rate.
Why It Matters
Real estate is one of the most tax advantaged assets that one can own. Understanding how to navigate these different benefits, can help an investor maximize their returns. As an active investor however, it can be difficult to do so effectively. When investing with a private equity group like Freshwater, much of the tax related headache can be reduced to a minimum, allowing investors to fully take advantage of real estate’s many tax breaks and benefits.