A Few Words About Taxes
The amount of capital gains tax you must pay depends on several factors, including how long you owned the property and if it has been fully depreciated. The sale of a personal residence might be exempt if you have lived in it for two out of the past five years. Even your vacation home may be exempt if you meet certain occupancy requirements.
The two-year rule can be taken over and over, and is an excellent tax tool for investors who buy fixer-uppers, live in them while they are refurbished, then sell. The taxes you save will add up nicely, allowing you to acquire more desirable properties — or to depend less on financing dollars.
The IRS considers income from real-estate investments to be passive income, while salaries, commissions, and compensation for other services are classified as active income. The reasons are best explained by an accountant, but the important fact about the difference is the way the two categories are treated on a tax return: passive losses cannot be deducted from active income.
The tax laws were created to keep large investors from using real-estate investments as tax shelters, but smaller investors get a break. If you meet certain qualifications, the IRS allows you a $25,000 allowance for passive loss write-offs against your active income.
If your gross adjusted income is less than $100,000, you qualify for the entire allowance. If your income falls between $100,000 and $150,000, you lose fifty cents of the allowance for every dollar your income exceeds $100,000.
The IRS requires that you actively participate in the management of the property. If you handle all management issues yourself, then it's a given that you are actively participating. If you hire a management firm, you probably don't qualify. A tax professional can help you determine your status and, if you do not qualify, can point out changes that might help you next year.
Other Ways to Reduce or Eliminate Taxes
There are several tax credit program and other methods you can use to help you lower or avoid capital gains and other taxes, described here.
Federal Historic Designations
If your property has been designated a historic building, you might be entitled to a federal investment tax credit. You must follow the guidelines carefully in order to receive the deduction, so consult with experts before attempting renovations.
Special Property Tax Deductions
Some areas offer property tax deductions for elderly homeowners, veterans, and the disabled. Special deductions on farm taxes might also be available.
An area that's economically challenged might be designated as an enterprise zone, offering tax benefits for purchasing equipment and hiring employees.
HUD allows some repair expenses for some areas to be written off all at once, rather than requiring the property owner to use depreciation methods. The goal of this program is to encourage investors to invest and refurbish residences in inner-city neighborhoods.
The 1031 exchange is an IRS tool that allows investors to defer payment of capital gains tax if they swap one property for another. This method is described in Chapter 17.
Receiving money for a sale over a long period of time, rather than taking a lump-sum payment, reduces the amount of tax you must pay in any given year.
Tax laws are ever-changing, and a tax professional is one of your best sources of information for short- and long-term planning for your investment properties.