Real Estate is a tangible asset that is real property such as land, buildings, improvements, and the right to use and enjoy that land and all of its improvements. There are 3 basic categories or real estate; residential, commercial, and industrial. For now, we will focus on residential as it is the most common form of real estate that individuals invest in.
Investing in real estate offers income and capital appreciation (an increase in the price or value of assets). You can invest in real estate directly by buying land or property, or indirectly by buying shares in publicly traded real estate investment trusts or mortgage backed Securities.
When Investing directly in real estate, one way to produce income is renting. The net income after considering the expenses necessary to produce the revenues will have tax implications. These tax implications vary depending on the amount of personal use the owner has at the residence. See below information.
- If the property was used by the owner more than the greater of 14 days or 10% of the rental days, and the property was rented less than 15 days, then it is considered a “personal residence”. The income and expenses for a personal residence do not need to be reported.
- If the property was used by the owner more than the greater of 14 days or 10% of the rental days, and the property was rented more than 15 days, it is considered a dwelling unit. The income for a dwelling unit is reported and the expenses for a dwelling unit are prorated between personal and rental use.
- If the property was used by the owner less than the greater of 14 days or 10% of rental days, and the property was rented or held for rental, then it is considered rental property with personal use. The income and expenses are reported on Schedule E.
- If the owner has no personal use of the property, then the property is considered a rental. The income and expenses are reported on Schedule E and are subject to passive activity loss rules.
**There are other options such as renting out a part of the home exclusively (i.e. Bed and Breakfast), and property help under a Partnership or S Corporation, but I will table those topics for later discussion.
Passive vs Non-passive Activity
Most rental activities are classified as passive (activities in which the owner does not materially participate). Losses from passive activities are limited to passive activity income. The losses that are not allowed are carried forward to following tax years indefinitely. Non-passive activity is carrying out trade or business in which a taxpayer materially participates (i.e. wages or self-employment). Rental of a home is considered non-passive if the owner uses the home more than the greater of 14 days or 10% of number of days rented. Rental Real Estate activities are also considered non-passive if the owner materially participates as a real estate professional. The losses from non-passive activities are fully deductible, therefore the activity can result in a loss. There is an exception for passive activity loss that allows up to $25,000 of rental loss to be deducted each year against non-passive activity. The taxpayer must actively participate in rental management activities that are significant and real (i.e. approving new tenants, deciding rental terms, approving capital or repair expenditures, etc.). The $25,000 is subject to phase out based on modified adjusted gross income.
Another way to produce income through real estate investing is to sell the property. The appreciation of a property can be achieved in many ways, but the increase in value is not realized until the owner sells the property. The gain on the sale of residential real estate is taxed at capital gain rates. Some or all the gain may be excluded if the taxpayer meets the ownership and use test. See information below.
- If the home sold is the principal residence, then the taxpayer may exclude gains up to $250,000 or $500,000 if married filing joint. The owner must have lived in the home as a principal residence at least 2 of the last 5 years prior to the sale. This exclusion can only be used for 1 sale every 2 years.
- A home could still qualify for the exclusion of gain, even if it was converted to rental use. If the home was used as a personal residence for 2 of the last 5 years prior to the sale, then the exclusion still applies.
A mortgage-backed security (MBS) is a type of asset that is secured by a mortgage or a collection of mortgages. Mortgage-backed securities usually pay periodic payments that are like coupon payments from a bond. The interest portion of the payments are subject to federal, state, and local income tax. The portion of the payments that are return of capital or original cost is not taxable. Different rules apply if the security was purchased at a discount. If an MBS is purchased at a price less that its face value at the time it was issued, then the investor may incur tax liability on the interest that accumulates on the security. If the MBS is purchased at a discount in the secondary market, then the investor may have tax liability on the principal received in excess of the purchase price and the accumulated interest.
Unlike other investments, real estate is significantly affected by its surroundings and geographic location. Other than the occurrence of a severe national recession or depression, location is the most important factor that affects real estate value. Here are a few location factors to consider; local economy, crime rates, public transportation facilities, schools, municipal services, and property taxes.
What I have laid out are some pieces of foundational information when considering the idea of residential real estate as an investment. Although this information is very helpful, investing in residential real estate is an in-depth subject matter, so there are other things consider. The topics that I have touched on can be much more complicated. If any of this information is not clear to you, or if you have further questions or concerns please reach out to one of our professionals.
Arthur Harrison lll
Tax and Accounting