Understanding Capital Gains Tax of Property
Real estate can be a powerful wealth-building tool – if you understand how to use leverage and manage your tax liabilities responsibly. One reason for this is that capital gains tax of property are different from the taxes imposed on ordinary income.
Below, I’ve outlined a few of the different aspects of capital gains tax of property. With this information, you’ll be better informed to make wise real estate decisions about capital gains tax of property that may reduce your overall tax liability.
Ordinary Income Tax vs. Capital Gains Taxes
The Internal Revenue Code divides individual income into three taxable categories: “Ordinary Income,” and “Passive Income.”
Ordinary income includes hourly wages, salary, tips and other sources of regular income that you receive throughout the year. Capital gains refer to a profit from the sale of property or an investment. This can include the sale of capital assets like a business, real estate or stocks.
The term “marginal tax rates” is used to describe the tax rate on ordinary income. In 2018, the marginal tax rates ranged from 10% to 37%, depending on the taxpayer’s total ordinary income.
Capital gains tax (CGT) is used to describe the (usually lower) tax rates imposed on capital gains. In 2018, the capital gains tax rate ranged from 0% to 20%, depending on the taxpayer’s total capital gains.
Many taxpayers use real estate as a wealth building tool. This has its advantages, but it’s important to understand the entire picture before making a financial decision.
There is one main reason that capital gains tax of property are relatively lower than marginal tax rates:
- Some economists argue that the US government increases its total tax revenue when it lowers the CGT rate. Tax policy is sometimes used to spur economic activity. Lowering the CGT is one way the government can make private investment more appealing.
Passive Loss Rules
When discussing the impact of the taxes on capital gains tax of property, it’s important to understand the difference between active income/loss and passive income/loss. Generally speaking, income is considered passive if the taxpayer spends less than 500 hours per year earning it.
Deducting financial losses from taxable income is an important strategy for minimizing a taxpayer’s total tax liability. However, the IRS limits taxpayers from deducting passive losses from active income or portfolio income. Passive losses may only be deducted from passive income.
If the IRS didn’t do this, savvy taxpayers could “invest” in losing investments to strategically lower their taxable income, and this could move them into a lower marginal tax rate. The savings in taxes could considerably help offset the “poor investment decision.”
Passive loss rules can have a significant impact on a taxpayer’s total tax liability. Generally, you need to be a real estate professional, spending more than 500 hours per year on your real estate business(es) in order to deduct real estate losses from your active income and portfolio income.
Here are a few scenarios:
Full-Time Real Estate Developer
A full-time real estate developer is actively involved in the business because he/she is spending more than 500 hours per year managing their projects (site selection, acquisition, construction, renovation, sales, etc.). They should be able to deduct any losses from their overall tax liability.
A part-time landlord that spends less than 500 hours per year managing the rental of their properties may be limited in their ability to deduct real estate losses from their active income.
Multiple Business Ventures
What if they own and manage multiple businesses? This could mean that they spend less than 500 hours per calendar year managing their real estate investments.
The IRS will probably limit their ability to deduct any losses incurred from their real estate investments from their active income.
How Are the Various Businesses Related?
There are situations where taxpayers can group their various activities together to reach the 500-hour threshold, meaning the real estate profits are treated as active income.
One example is a married filing jointly couple, where each partner owns and actively manages a different business.
Another example could involve a single taxpayer that owns two or more mutually beneficial, closely related businesses.
The IRS recognizes that taxpayers sometimes split their active sources of income into multiple business entities. For example, a real estate developer that also owns a restaurant may have his/her restaurant lease space from a property his/her real estate firm owns. The cumulative time spent managing both businesses may qualify them to deduct losses in either business from their taxable, active income.
There are many variables here. It’s important to consult a qualified tax professional to discuss your specific situation. And it’s also a good idea to accurately track your time invested in different activities. An accurate time log makes this much easier to analyze – especially in the unfortunate event of an audit.
Depreciation is a powerful tool for reducing your tax liability. If you own a rental property, and it is actively available to (potential) tenants – it is advertised as available for rent, or actively rented – you may be able to deduct a portion of the property’s value from your taxes.
The land is not depreciable (hopefully it’s increasing in value), but you can deduct a portion of the value of the property that has a shelf-life.
For example, the structures on your property have a defined usable life. The value of your structure can be used to help determine your annual deduction for depreciation.
Taxpayers need to remember that the property must be actively available or in use as a rental income property to qualify.
A trained, qualified tax professional can help you determine whether it is best to use the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) for calculating your annual deduction.
Section 1031 of the Internal Revenue Code allows some property owners to defer the payment of capital gains tax of property that is sold, as long as the funds are promptly invested in similar real estate property.
This can be a lifesaver if the property you are selling has substantially increased in value during your tenure of ownership. The value of the new home must be greater than or equal to the previous property. If there was a mortgage on the original property, there must also be a mortgage of equal or greater value on the new property.
Capital gains tax of property can be complicated. The implications of CGT can dramatically impact your tax liability at the end of the year. It’s my sincere hope that the topics outlined in this article help you to gain an understanding of how CGT works in regard to real estate.
But remember, it’s impossible for this article to provide specific tax guidance for your specific situation. Always consult a qualified tax liability expert in your area about capital gains tax of property before making important financial decisions.