The taxation of real estate is misunderstood by most investors. Many are not aware of the drastically different tax outcomes until the realization bites them during an IRS audit. The tax rules for real estate are some of the most complex in the Tax Code.
The types of tax and legal structures chosen create a variety of tax treatments when combined with other factors depending on how title is held; investors’ intentions; whether activities are investment or business; whether the investors are passive or active or materially participate in the activity.
The variables create different amounts of taxes and complexity depending on whether properties are held long-term; as rental properties; for resale; the average length of time a tenant stays or whether an owner provides services other than basic maintenance.
Sales, exchanges or transfers of real estate
When investors plan to sell rental properties to buy others, a 1031 exchange should be considered. The exchange allows taxes to be deferred to the future, but can be completely avoided if done properly.
Two other “investors” were audited on the sale of their real estate. Each sold identical properties and each reported their gain at the 15% capital gains rate. The IRS accepted the one as filed, but taxed the other’s gain at a whopping 43%.
The second “investor” had flipped the property and wasn’t eligible for the lower capital gains rate, because he wasn’t an investor, but a dealer according to the Tax Code.
The IRS re-calculated the tax on the gain from a 15% capital gain rate to a 28% ordinary income rate, then added an additional 15.3% self-employment tax on top of that for a whopping 43.3% tax rate—nearly a 300% increase over what was reported.
Before selling, exchanging or transferring real estate it’s important to do some tax planning and to know the tax outcome before transactions occur. Real estate transactions are big ticket items and the taxes can add up quickly.
See our other articles to gain a fuller understanding of the taxation of real estate.