Real estate is a great way for physicians to build wealth, achieve financial independence, and create a second stream of passive income. It also provides advantages such as giving you more control over your investments and even giving you some tax breaks. Speaking of tax breaks, real estate affects your taxes differently than other investments, so understanding the tax implications of real estate will help you make smart decisions before diving in and purchasing your first real estate investment. If you are ready to understand how real estate affects your taxes, keep reading to find out more.
How Single-Family Rental Properties Affect Your Taxes
When you own a single-family rental property, you receive income in the form of rent and can take various deductions for expenses related to your investment including repairs, management fees, property taxes, advertising, and many other expenses. These deductions reduce your total rental income and thus reduce the amount you will be taxed on. Make sure you keep track of all the expenses related to your rental property, so you can take as many deductions as possible come tax time.
Rental income and deductions are reported on Schedule E of your IRS form 1040. Real estate is considered a passive activity by the IRS, and if you show net income from your investment property, your income will be taxed at your ordinary income tax rates. If you show a loss, you will need to understand the concepts of active vs. non-active participation in passive activities such as real estate.
Normally, you cannot deduct passive losses (i.e. real estate) from your active income (i.e. salary and wages). However, if you actively participate in your real estate investment, there is a special allowance that lets you deduct $25,000 of your real estate losses against your normal income.
What is active participation?
It is pretty easy to be considered an active participant in your real estate investment. Typically, you are considered an active participant if you make management decisions for your property such as advertising your property, collecting rents, approving tenants, and other similar activities.
This $25,000 allowance is phased out once your modified adjusted gross income reaches $100,000 and is completely phased out at $150,000. This unfortunately will leave many physicians without the ability to take this $25,000 loss due to their higher than average salaries.
As an example, if you are a resident earning $60,000 per year and own a rental property that generates a loss of $15,000, you can deduct that entire $15,000 against your wages and reduce your taxable income to $45,000.
If you do not actively participate in the management of your real estate investment, then you will be subject to the passive activity loss rules and at-risk rules outlined by the IRS. These rules generally state that you cannot deduct passive activity losses against active income. You can only deduct passive losses against passive income. If your passive losses exceed your passive income, then you will have to carry forward those passive losses to a future year when you have passive income that exceeds your passive losses. We will cover the at-risk rules and passive activity loss rules later in this article.
One deduction that is unique to real estate investing is depreciation. Depreciation allows you to deduct a portion of the cost of your property each year on your tax return, which also helps reduce your rent income. Since depreciation is a non-cash expense, there is a possibility that you could have positive cash flow from your real estate investment and show a “paper loss” on your tax return. This is great for you because you will have cash in your pocket and a loss on your tax return which will help you pay less tax.
A couple of things to note about depreciation.
First, you can only depreciate the cost of the structure. When you buy a rental property for $200,000, a portion of that cost is for the building and a portion is for the land. If you determine that 75% of the cost is for the structure, then you can only base your depreciation calculation on the cost of $150,000 ($200,000 x .75). Also, the IRS sets the number of years you can depreciate your rental property, and currently, that number is 27.5 years. In the above example, you could depreciate and deduct $5,455 on your tax return every year related to your rental property ($150,000/27.5). Adding to this example, if you are showing a net rental income of $3,000 before accounting for depreciation, then your net income after taking depreciation would actually be a loss of $2,455. Not a bad way to reduce your rental income!
However, this leads to the other point about depreciation. When you deduct depreciation every year, you are actually reducing the cost basis of your investment. That means when you go to sell the property you will have to pay capital gains tax on all the deprecation you have taken over the years. This is commonly called “depreciation recapture”.
Let’s say you hold the property we mentioned above for 27.5 years and fully depreciated the property. Your cost basis for the building would be reduced to $0. If you sell the property for $300,000, you have to pay capital gains tax on $250,000 of the sale price because your gain is now calculated as the sales price of $300,000 minus your current cost basis of $50,000 (The $50,000 is the cost basis of the land. Since you fully depreciated the building, your cost basis for the building is now $0). This will create a large tax burden for you when you go to sell your property. Luckily, you will pay tax at the long-term capital gains rates which are more favorable than the ordinary income rates. Don’t let this surprise you when you go to sell your rental property.
Hold Real Estate Until You Die and Pass It to Your Kids
As you can see, selling your real estate could lead to a large capital gain and tax burden, depending on how long you hold the property and what you sell it for. Fortunately, the IRS has created a way for you to avoid paying capital gains on your real estate.
If you never sell your real estate and hold your rental property until the day you die, your heirs will receive the real estate on a stepped-up basis.
This means your heirs will inherit the property at the current fair market value (FMV) of the home on the day you die, regardless of what the prior cost basis was. This is huge because now when your heirs go to sell the property at a later date, their capital gain is calculated based on this new, stepped-up basis, not your original cost basis.
Here’s an example.
You purchase a property for $200,000 and hold it for thirty years. Because of depreciation, the cost basis is reduced to $50,000 which is the cost of the land that can’t be depreciated. If you were to sell the property in year 31 for $400,000 you would have a capital gain of $350,000 ($400,000 – $50,000) which you would owe taxes on.
However, if you die in year 31 and pass the property to your heirs, they get a stepped-up basis and receive the property at the current FMV on the day of your death which is $400,000. If your heirs then decide to immediately sell the property for $400,000, the calculation of their gain is based on their basis of $400,000, not your basis of $50,000. Therefore, their gain on the sale is $0 ($400,000 – $400,000), and you have effectively avoided paying taxes on a huge amount of capital appreciation.
Buying and holding real estate forever is a great way to build wealth for you and your future generations.
How Non-Active Real Estate Investing Affects Your Taxes
Owning single-family homes is a great way to build wealth with real estate. However, unless you hire a management company, this type of investing will likely require you to actively participate to some extent.
If you decide to participate in real estate crowdfunding or form a partnership with someone, you could become more passively involved in real estate investing. Choosing this path for real estate investing is great if you want a more hands-off approach. With these more passive types of real estate investing comes different tax implications than single-family rentals.
Investing in Real Estate through a Partnership
When you invest in real estate through crowdfunding you are participating in a partnership as a limited partner, so you will receive a K-1 tax form. The same goes for if you invest in real estate by forming a partnership with someone you know. You will still receive a K-1 tax form.
This is because partnerships don’t pay tax at the corporate level. Instead, they pass their income (or loss) to the individual partners who then report the income or loss on their individual tax return. The K-1 tax form is what the partnerships pass out to their partners showing them their share of the income or loss they should report on their individual tax return.
When you invest in real estate through crowdfunding you are considered a limited partner in that partnership. Similarly, if you form a partnership with someone you know, depending on your level of participation and percentage of ownership, you may also be considered a limited partner.
If you are a limited partner participating in a real estate investment, you are not actively participating in a passive activity. This means the losses you can deduct on your tax return will be limited based on the at-risk and passive activity loss rules.
The at-risk rules state you cannot claim a loss for more than the amount you have at risk in the investment. The amount you have at-risk increases annually for the contributions you make and the income you earn from the investment. Your at-risk amount decreases annually based on distributions given to you and losses reported from the investment.
So if you contribute $10,000 to a passive real estate investment activity, you could only claim a loss of up to $10,000 on your tax return, even if a loss greater than $10,000 was reported to you.
If a loss is reported to you that is greater than your at-risk amount, the additional amount is carried forward until you have enough at-risk in the investment to claim the additional loss.
Passive Activity Loss Rules
The passive activity loss rules are pretty straightforward. You can only deduct passive losses from passive income. If your passive losses exceed your passive income, you can carry forward the excess passive loss to a future year when you have passive income to deduct it against.
At-Risk and Passive Activity Loss Rules Combined Example
It is important to know that you must follow the at-risk rules first, then move on to the passive activity loss rules to determine how much of a loss you can deduct on your tax return related to a passive real estate investment that you do not actively participate in. Here is an example to illustrate that point.
You invest $10,000 in a limited partnership real estate investment making you a non-active participant in a passive activity. During year 1, a $15,000 loss is reported to you. Because you only have $10,000 at-risk in the investment, you can only possibly deduct $10,000 on your tax return. The remaining $5,000 loss can be carried forward until your at-risk amount increases from either positive earnings from the investment or additional contributions you make.
Before you deduct this $10,000 on your tax return, you must now apply the passive activity loss rules.
Since investing in real estate as a limited partner is a passive activity that you do not actively participate in, you can only deduct the $10,000 passive loss against other forms of passive income. If you don’t have passive income, you can carry this loss forward. If you do have other forms of passive income, you can deduct up to $10,000 against that income.
So if you have $4,000 in passive income, you can deduct $4,000 of your $10,000 loss on this year’s tax return, and carry forward the additional $6,000 passive loss to a future year.
As you can see, it is possible to have carryforwards from both the at-risk rules and the passive activity loss rules. You will want to keep these rules in mind before deciding to invest passively in real estate.
Your K-1 Tax Form
Now that you know the at-risk and passive activity loss rules, let’s take a look at the K-1 tax form.
You receive a K-1 tax form from a partnership. It shows you your share of the partnership’s income or loss for the year. It also shows some general information including your percentage ownership in the partnership which is based on the amount you originally invested and the partnership agreement. This is shown in Section J of your K-1.
Also in the general section is Section L which shows your capital account. This is your at-risk amount in the partnership that increases or decreases annually.
The rest of the K-1 is the portion you will use to fill out your individual tax return. Since we are dealing with real estate we will focus on the K-1 boxes that are most likely to affect you. Many of these boxes will be reported on Schedule E on IRS form 1040 which is the same tax form where you report your income or loss from rental properties.
Box 2 and 3 show your portion of the net rental real estate income or loss from the partnership’s activities. If income is reported in box 2 or 3, you will report this income on your Schedule E, which will then flow to your 1040 and be taxed at your ordinary-income rates. If a loss is reported, the loss might be limited because of the at-risk and passive activity loss rules. You can use IRS form 6198 (At-Risk Limitations) and 8582 (Passive Activity Loss Limitations) to help you determine how much of a loss you can report on your tax return for the year.
If a net short-term capital gain or loss is reported in box 8, you will report this on Schedule D. Gains will be taxed at your normal, ordinary income tax rates because the nature of the gain is short-term.
If a net long-term capital gain or loss is reported in box 9a, you will also report this on Schedule D. Gains will be taxed at the more favorable long-term capital gain rates.
Box 9c reports your portion of unrecaptured section 1250 gains. These are the gains that you must record on the sale of an asset due to the prior depreciation of the asset. Remember, when real estate depreciates, its cost basis is being reduced by the amount of the depreciation. Unrecaptured section 1250 gains are the gains you now record because of the decreased cost basis of the real estate due to depreciation. You report these on Schedule D.
Distributions in box 19 will decrease your capital account, and if you receive distributions in excess of your capital account, that income will be taxed as a capital gain.
How REITs and REIT ETFs Affect Your Taxes
Real estate investment trusts (REITs) and REIT ETFs are other ways you can add real estate to your portfolio without owning physical real estate. REIT and REIT ETFs can be bought on most public stock exchanges.
When you buy a REIT or REIT ETF you become a unitholder of that REIT. A REIT will then make distributions to its unitholders in a few forms.
First, a REIT can distribute a portion of its operating profit to its unitholders. Unitholders are then taxed at their ordinary income tax rates for these distributions.
Second, if a REIT sells an asset, unitholders may receive a capital gain distribution. Unitholders are then taxed at their ordinary income tax rates if the holding period was short-term or long-term capital gain rates if the holding period was long-term.
Finally, a REIT can make a return of capital distribution to its unitholders. In this case, the distribution reduces the unitholder’s cost basis in the investment and is not currently taxable to the unitholder. However, when the unitholder sells the REIT in the future, this decreased cost basis means their gain will be larger upon the sale of the REIT, thus leading to paying more taxes on the gain of the sale.
Closing the Door on Real Estate Taxes
Owning real estate is a proven way to build your wealth and achieve financial independence for you and your family. Before deciding to take on real estate investing, it is important to understand the tax implications of the different types of real estate investments available to you. Hopefully, you can reference this article when you start thinking about investing in real estate and the effect it will have on your taxes.