Looking to Invest in Real Estate? The Taxes Are in Your Favor
Investing in property for sale in Kona Hawaii can be incredibly financially rewarding. What many investors don’t anticipate when calculating their projected profits, though, is the impact that real estate investment can have upon your taxable income. Different forms of income — job income, rental income, income from long-term capital gains — are taxed at different rates. Furthermore, the money you make in your real estate ventures will impact the tax bracket in which you are placed. It is not uncommon for higher taxation to offset many of the investment profits investors generate. Luckily, though, the IRS tends to operate in the favor of real estate investors. Read on to learn more about how investing in property for sale in Kona Hawaii can actually generate tax benefits that will increase your bottom line.
Depreciation Expenses…
The value of current property for sale in Kona Hawaii will inevitably decrease, or depreciate, over time. The IRS estimates that the value of residential real estate will wear down in approximately 27.5 years. Depreciation is considered a “paper loss,” or a business expense that occurs without any money transaction.
As a sort of invisible expense, it might seem that depreciation would yield negative financial repercussions for real estate investors. However, the IRS actually allows you to subtract the estimated depreciation of your property from your taxable rental income. For example: Without depreciation expenses, you would have to pay $2,500 in taxes on a rental income of $10,000, assuming a federal income tax rate of 25%. However, if the IRS permits a depreciation expense of $4,000, your taxable income declines to $6,000. Thus, depreciation expenses decrease your taxes owed to $1,500, saving you $1,000.
If your depreciation expense exceeds your rental income, you obtain a “passive loss.” While passive losses still reduce the tax owed on your rental earnings, they are not capable of sheltering other sources of non-passive income. In other words, and with only a few exceptions, you are not permitted to deduct these losses from taxes owed on your job income or financial assets.
You should also keep in mind that these benefits are not everlasting. Should you choose to sell your rental property, you will likely have to recapture the depreciation and pay a 25% tax on it. If you are investing for the purpose of reducing your taxable income, plan to invest in a property for sale in Kona Hawaii that you will want to hold for an extended period of time.
But NO Appreciation Expenses
Though the IRS allows you to reduce your taxable income by the amount your property depreciates, it does not require any adjustment to your taxable income should your property appreciate in value. Thus, investing in renovations and remodels to add value to your property will have no negative taxation repercussions. This is, of course, great news for investors. It is also great news for renters, whose landlords have greater incentive to upgrade their properties.
FICA
Per the Federal Insurance Contributions Act, or FICA, all employees must pay a tax for Social Security and Medicare programs. As of 2016, salaried employees pay a 7.65% FICA tax rate on their income. Self-employed individuals pay even more—15.3% of their total income.
Rental income, however, is not subject to FICA. While this exemption may seem insignificant, it generates notable savings in contrast to typical income. Whereas a $60,000 salaried income necessitates a $4,590 FICA tax deduction, $60,000 in rental income will cost you $0.
Long-Term Capital Gains
The IRS defines long-term capital gains as the profit generated on investments held for a period of over one year. These profits are, of course, subject to a tax rate between 0% and 25%, depending upon your income bracket. Taxes on long-term capital gains are almost always lower than those on general income. Thus, investing in property for sale in Kona Hawaii that generates profit qualifying as a long-term capital gain can be much more profitable than working a salaried position or investing to generate short-term capital gains, which are taxed as regular income. Furthermore, rental depreciation and tax deductions are likely to place you in a lower tax bracket. Thus, maintaining a rental property not only reduces taxes owed on rental income; it also reduces the taxes you owe on your long-term capital gains.
Even better: if you live in your property for two out of the five years that follow your purchase, the profit you generate in those other three years is not subject to any taxation at all. In the United States, an individual can generate up to $250,000 in non-taxable profit on a property in those five years so long as they occupy the residence for two. Many investors choose to undertake what is known as a “Live-In Flip” during this period. In other words, investors both reside in and flip the house in the necessary 2-year residential period. Doing so allows them to generate even more non-taxable profit in the three years after.
1031
A 1031 tax exchange allows you to avoid both the depreciation recapture tax and taxes on long-term capital growth. By using a 1031 tax exchange and trading one property for another to eliminate taxes, you increase the profit available to re-invest in another property for sale in Kona Hawaii. That means that the property that you trade for could be higher in value than if you had decided to simply invest in an additional property. For example: if you sell a $200,000 property using a 1031 tax exchange, you save could save $25,000 in taxes for use in future investing.
Installment Sales
Installment sales are another method that the IRS provides for investors looking to eliminate the long-term capital gains tax. Using an installment sale, an investor can reduce annual taxes owed on a property that they have sold by permitting the buyer to pay the seller a monthly payment (plus interest) on the total value of the property. Installment sales thus allow buyers to forego bank loans and instead receive a line of credit from the seller/investor.
Say an investor sold a property for $300,000. Without an installment sale, the investor must pay taxes on all of those $300,000 that year. In so doing, he or she would land in a higher tax bracket, thereby increasing overall taxes owed. Using an installment sale instead, the investor may only receive $30,000 in payments in a year. Thus, her or she must only pay taxes on those $30,000. In turn, her or she would fall into a lower tax bracket, reducing overall taxes owed.