Curious about investment properties and how that income can be taxed? Let me begin by telling you a little story that happened not too long ago in a city not too far away.
Once upon a time, there was a tax advisor sitting in his office going through a regular tax return with a client. The sun was shining, birds were singing, and everything was ok in the world. Bob (the client) had gone to a few motivational seminars about rental real estate, made some life changes and this was the first year of taxes with his new income stream. When Bob looked over the initial draft of his tax return with the majestic tax advisor – the birds stopped singing and dark clouds obscured the sun.. “but I thought rental income was taxed as capital gains?!”
It is true life is not 100% the fairy tale wonderland that I choose to narrate my life memories in, and Bob is certainly not the name of this person. This was actually a conversation starter that happened in real life. This is what prompts this blog post, which is the realities of different investment properties, their income and the taxation of them.
Investment Property – Rental Income
Let’s first go back into the fairy tale wonderland with Bob and his residential rental home(s) income. First of all, it actually matters if Bob is a very hands on, do everything himself kind of guy. If Bob runs around to the different houses, does all the repair jobs himself, mows the lawns, is the landlord / maintenance / everything else, then Bob is actually self employed and should recognize the income as such. Self employment income carries an extra tax (self employment tax) and most don’t get that involved in their rental properties, so we aren’t going to dive into that rabbit hole.
Bob is very much the typical owner of rental real estate. He loves to collect rent and not have anything break or need fixed so he keeps as much of the rent for himself as he can. Bob is not selfish, he is just a good businessman. This kind of income is ordinary income to Bob. It is not taxed extra as self employed, nor does it get lower taxation like capital gains. The rents are offset by many deductions, like property taxes, insurance and writing off a portion of the structure itself every year. What is left, or the profit, is what is taxed. We have another article on our website with a little more / different detail on residential real estate here: https://molentax.com/things-to-know-before-investing-in-residential-real-estate/
Selling Rental Properties
There is one other event of taxation involving a rent home, and that is selling it. The selling of a rent home is generally a capital gain, but not a normal capital gains. Normal capital gains for something owned for more than a year have a 0% ,15%, or 20% tax. 20% requires pretty substantial yearly income, most pay 15%. What happens is every year on your tax return, you can ‘depreciate’ or write off a portion of the rental home (structure only, not land). This helps offset rental income and you love it. However, writing something off has a consequence later on. The simplest way to describe it is writing something off, or depreciating it, is lowering your initial purchase price.
Example:
I buy a hammer for work for $15.00. I write off that hammer on my taxes as part of my construction business. For tax purposes, I have now paid 0 dollars for that hammer. If it is lost or stolen, my cost is 0 and I have no loss – if I were to sell it for $10 bucks… I paid $0.00 for it and now I need to recognize $10 of construction business income.
When you sell a rental home, your gain for tax purposes will be more than the difference of what you bought it for vs what you sell it for. You have to add it to the recapture of depreciation, or rather adjust your purchase price in accordance with what you already wrote off.. thus it would look more like this:
Selling price – purchase price – depreciation = how much you ‘made’ or your gain from the sale
https://www.investopedia.com/terms/u/unrecaptured-1250-gain.asp has a decent explanation and example as well. Generally speaking, residential rental real estate is section 1250 property. Not things you have to know or memorize, just so you know why that link is applicable.
The catch with the sale is that the portion of your gain that came from your write off is taxed differently than the rest. Boiling it down, the depreciation recapture follows your regular, ordinary tax brackets up to a max of 25%. It is still a preferential, or ‘lower’ tax than ordinary income, but only if you would be taxed more than 25%. Thus if Bob’s tax gain by selling a rental home is $85,000 and $45,000 of it was front depreciation, $45,000 will follow normal taxation up to a max of 25%, and the other $40,000 will be taxed as long term capital gains – likely 12%, but it depends on Bob’s other income.
You still with me?
It isn’t totally vital to fairy tale land that you understand the intricacies of the selling of the property, but the general idea that your gain for tax purposes will be much larger than anticipated and is always worthy of a consult with a tax advisor before it occurs.
The concept of depreciation recapture is true for commercial properties as well. It may not qualify for section 1250 property and the taxation numbers could be different, but the taxable gain being increased by depreciation taken over the years, will happen. Please consider planning, and or tax planning accordingly for the year that will happen. There are a number of additional items that can be included in the taxable gain calculation to your benefit, such as improvements and closing costs – it is worth the time and or money to get an accurate feel ahead of time of the tax impact of selling a rental home will be.
Investment Properties & Land
Buying land, letting it appreciate in value and selling it has no magic around it. No fairy tale, just a boring no color old movie. If you have the land more than 1 year, which is the most common as land needs time to appreciate – then it is a capital gains when you sell it. It doesn’t matter how much it is worth, it is only income when you sell it – just like stocks. Which can matter greatly when considering inheritance as well, having land, or a house is not income.. until you sell it (or rent it of course).
Investment Properties + Flipping Houses
The one last tidbit about investment ‘property’ I will chime in on, is flipping houses. Flipping houses with regularity (2-4 + per year) makes my tax brain go to the place of being a business. However, the IRS is pretty strict in this regard and their strictness almost feels backwards. They don’t want to allow all the deductions that can be connected with being in ‘business’ unless you meet a very high bar of being a ‘dealer’ in said thing. Consequently, flipping homes should be listed on Schedule D and subject to capital gains. Selling within 1 year is short term and subject to ordinary tax, but if you have the ability to hold a few homes more than 1 year while you fix them and sell days after the 1 year mark, you will only pay the lower long term capital gains rates – which can be quite.. fairy tale like.
None of these things are bad and should be off putting, the goal here is simply to help keep the birds chirping and the sun to stay out – and the dark ominous music of a nasty surprise does not happen.
And they lived happily ever after.
At Molen & Associates we handle all degrees of difficulty when it comes to taxes and tax returns. If you find yourself needing a tax advisor please give us a call at 281-440-6279. We aim to resolve your tax headaches and ultimately get you the best refund possible.
Charles Steinmetz
Senior Tax Advisor