There are many benefits to owning a house. You now have your own home, which you can decorate, remodel, and renovate as you see fit. When you pay off your debt, you increase your equity. Certain expenses, such as mortgage interest and property taxes, can also be deducted from your income tax bill.
This article is just to give you an idea of the general workings: Since I am not an accountant and tax laws are complex and change regularly, you should work with a reputable tax accountant or CPA to ensure you get the best tax advice possible.
On the contrary of Italy (where I am from), the US tax laws are friendly to landlords: There is a need in the US for affordable rental housing, so the tax laws are made to encourage landlords to rent, giving us several ways to deduct our expenses (like depreciation).
Even so, it’s a good idea to consider the tax consequences of buying or investing in real estate. Here’s a primer on real estate taxes to get you started (check again with your CPA).
Taxes and deductions for the real estate owner
Real estate taxes
If you own a house, you’re probably acquainted with property taxes. The local government collects real estate taxes to help finance programs and projects that benefit the community, such as health care, libraries, colleges, and highways.
You pay these taxes to the local tax assessor once a year or include them in your monthly mortgage payment. Property taxes are calculated using the assessed value of your land and any buildings on it.
As long as you own the house, you must continue to pay real estate taxes. You don’t stop even if your mortgage is paid off, and you don’t stop if you no longer live in the building. If the property is in your name, you are responsible for the taxes.
Since property taxes change over time, the bill could be higher or lower than in previous years. This can occur when your home is reassessed or when the municipal government changes the tax rate (either up or down).
A warning: Some states like New Jersey charge the highest average state tax in the US at 2.49% yearly.
Property tax in some states is quite expensive, so always check before you buy.
I live and invest in Maryland. Maryland’s average effective property tax rate of 1.06% is just below the national average, which is 1.07%. However, because Maryland generally has high property values, Maryland homeowners pay more in annual property taxes than homeowners in most other states. However, check before you buy; I speak from experience since I bought a property in Baltimore City, and the city has the highest rate in Maryland. The total listed tax rate in Baltimore is $2.248 per $100 of assessed value, more than twice the rest of Maryland.
If you buy in Washington DC, you will have to pay special attention to property tax. DC is penalizing, for example, vacant buildings at a 5% tax rate and penalizing even more dangerous unsafe building at a 10% rate
What choices do you have for lowering my property tax bill?
Tax Rate per $100
Residential real property, including multifamily
Commercial and industrial real property, including hotels and motels, if the assessed value is not greater than $5 million
Commercial and industrial real property, including hotels and motels, if the assessed value is greater than $5 million but not greater than $10 million
Commercial and industrial real property, including hotels and motels, if the assessed value is greater than $10 million
Vacant real property
Blighted real property
If your real estate is over-assessed, you could be paying too much in taxes. If you think the assessor made an error, you have the right to appeal the estimated value of your house.
Seniors, veterans and their remaining families, people with disabilities, and owners of agricultural property may be able to minimize their tax bill by using programs that offer tax deductions and exemptions.
Furthermore, most states provide homestead tax breaks, which exclude a portion of your home’s value from property taxes.
Capital gains taxes in Real Estate
Another form of tax that homeowners and investors may have to pay is capital gains tax. You would be subject to this tax if the proceeds from selling your land surpass the cost base.
Your net proceeds are the sum you got after deducting all transaction costs. The cost basis includes the purchase price, closing costs (mortgage application fee, valuation fee, home inspection fees, transfer taxes, and so on), and the cost of any major changes (replacing the roof, adding a bathroom, etc.).
The sale price or net proceeds are not subject to capital gains tax; only the benefit (i.e., profit) is. To calculate the profit, subtract the cost basis from the net proceeds. If the number is negative, you have lost money. If the result is good, you make a profit and will pay either income tax or capital gains tax, or both. Capital gain tax in the US is usually much lower than income tax, so if you do a flip, a way to pay fewer taxes is to rent the house for a while, then sell it and pay capital gain taxes instead of income taxes.
Capital gains tax exemptions
Most homeowners will deduct up to $250,000 in capital gains from the sale of their primary residence ($500,000 if married filing jointly).
To be qualified, the house must be your primary residence, you must have lived in it for at least two of the previous five years (the years do not have to be consecutive), and you must have owned it for at least two of those five years.
Short-term and long-term capital gains tax rates
Suppose your gains exceed the exclusion, or you don’t apply for one. In that case, you’ll report the benefit on Schedule D (Form 1040), Capital Gains, and Losses. You’ll pay different tax rates depending on how long you’ve owned the land:
• It’s a short-term advantage if you’ve owned the house for less than a year. These profits are taxed as ordinary income.
• It’s a long-term advantage if you’ve owned the house for more than a year. These are normally taxed at a much lower rate.
Deductions for homeowners
You may be able to reduce your property tax bill by appealing your assessment or taking advantage of deductions, exemptions, and discounts. However, you may minimize your taxable income by claiming one of the homeowner deductions mentioned below:
• Federal and state income taxes (the SALT deduction). Property taxes, federal and state income taxes, and state and local sales taxes will be deductible up to $10,000 ($5,000 if married filing separately).
• The interest payment on your home: you will deduct up to $750,000 in interest paid on a first and/or second home mortgage debt ($375,000 if married filing separately). Suppose you bought your home before December 15, 2017. In that case, you could deduct mortgage interest on debt up to $1 million ($500,000 if married filing separately).
Taxes and deductions for property owners
Property taxes are paid by real estate investors, including homeowners, and some tax breaks are accessible.
On average, real estate owners pay three types of taxes:
LLC Personal property taxes:
Suppose you are an investor and you opened your LLC. In that case, it is worth noting that some jurisdictions tax the personal property of corporations (i.e., non-real-estate property that the business owns). Equipment, furniture, benches, and other items that aid in the production of money are included.
Suppose you have an estate that is subject to these taxes. In that case, you must file a Business Property Statement (or something similar) per year. After an assessor determines the overall value of your personal property, the tax office issues you a bill.
Real estate rental income is taxed as ordinary revenue
Rent is taxed at the same rate as other forms of profit. Your real estate revenue is measured by deducting any deductible expenses from the land rentals you earn (more on those later).
Real estate sale and Capital gains taxes
If you sell an investment property for more than you paid for it, you must pay capital gains tax. Since their properties are not their primary residences, real estate owners seldom apply for the exclusion.
Though homeowners can deduct up to $250,000 in gain ($500,000 if married filing jointly), real estate investors typically do not qualify because their assets are not their primary residences.
Tax cuts available for real estate owners
If you owned the property for less than a year, as in the case of a house flip, the sale would result in short-term capital gains. It is taxed at a lower, long-term rate if you hold it for a longer period of time.
As a real estate owner, you must pay taxes on your real estate, profits, and capital gains. However, some tax breaks will allow you to save money.
If you purchase an investment property instead of a home, you will deduct further expenses. In fact, you can deduct all legitimate property-related expenses, including mortgage interest, property taxes, insurance, operating expenses, and maintenance and repairs.
You claim these deductions in the same year that you spend the money, and you report them on Schedule E (along with any rental income).
Depreciation is a concept that refers to the process of losing value.
You may still deduct the cost of buying and improving the land, but the rules are different. Rather than taking a single big deduction when you purchase the land, you depreciate the costs over the course of the property’s “useful life.”
A rental property can be depreciated if it meets four conditions, according to the IRS:
You own the land and use it for your business or a different source of income.
The useful life of the property can be estimated. It must be something that ages, decays, is depleted, becomes redundant, or loses value due to natural occurrences.
The land would be leased for a minimum of a year.
A property placed in service and then sold (or removed from service) cannot be depreciated in the same year. You cannot depreciate land so that it does not wear out, become depleted, or become obsolete. You must measure the value of the land and subtract it from your cost basis to determine how much you can depreciate.
Any residential property that is put into service today will depreciate for 27.5 years, any commercial property over 39 years. This equates to a 3.636 percent deduction from your income tax of the cost base each year for residential.
Depreciation will continue for up to 27.5 (or 39) years or until you sell the property, whichever comes first.
When you sell a rental home, you can use these exchanges to defer paying capital gains taxes.
A Section 1031 swap is a contract in which one investment property is exchanged for another. To put it simply, you sell one property and use the proceeds to buy another “like-kind” property. In the meantime, you can stop paying capital gains tax.
To qualify for a 1031 swap, you must meet three conditions with the sale:
The substitution must be of comparable quality. It’s like-kind whether it’s real estate held for beneficial use in a trade or industry or as an investment.
Any “boot” you sell must be taxed in the year you make the deal, regardless of whether you live in your primary residence or not. The boot is the fair market value of a non-like-kind currency, benefits, or other property obtained in a trade.
You must find and purchase the replacement like-kind property within 45 days of selling the first property and within 180 days of selling the first property.
NOTE: If you inherit the property from your close relatives, the cost base of the property resets. Simplified example if you buy a property for 100,000US and then sell it for 1,100,000, you pay capital gain taxes on 1 million. But you happen to die, and your son or daughter inherits, and the value of the real estate is 1 million at the time; if he sells it for 1,000,000, the base value rests, and he pays taxes only on 100,000.
When you buy, you have to consider the Property tax because it will influence your NOI negatively. You will also have to consider depreciation which will instead deduct that money from your tax filing.
Plus, not to forget that real estate investing is a great way to build your wealth forever, and you can read about it in detail here. (Link the article)