If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax.
Deductions for homeowners
You may be able to lower your property tax bill by challenging your assessment or by taking advantage of deductions, exemptions, and discounts. But you can also lower your income tax burden by claiming one of these deductions for homeowners:
- State and local taxes (the SALT deduction). You can deduct up to $10,000 ($5,000 if married filing separately) of combined property taxes and either state and local income taxes or state and local sales taxes.
- Mortgage interest. You can deduct the interest you pay on up to $750,000 ($375,000 if married filing separately) of mortgage debt on a first and/or second home. If you bought the home before Dec. 15, 2017, you can deduct mortgage interest on debt up to $1 million ($500,000 if married filing separately).
Taxes and deductions for real estate investors
Like homeowners, real estate investors pay property-related taxes and enjoy certain tax breaks.
In general, real estate investors pay three types of taxes:
Property taxes. Typically, investment property is assessed at its "highest and best use." In general, that’s the most profitable use of the property. But it also must be legally permissible (e.g., no zoning or deed restrictions that would preclude that use of the property), physically possible, and financially feasible.
That value is multiplied by the local tax rate to determine the amount you owe. The tax rate is usually higher for commercial real estate than it is for residential properties.
Note that some jurisdictions also tax business personal property (i.e., non-real estate property that the business owns). This includes equipment, fixtures, furniture, and other items that help you make money.
If you have an investment somewhere that imposes these taxes, you must file a Business Property Statement (or something similar) each year. After that, an assessor determines the collective value of your personal property and the tax office sends the bill.
Real estate income taxes. Rental income is taxed as ordinary income. Your real estate income is everything you earn from rents on the property less any deductible expenses (more on those later). Use Schedule E (Form 1040), Supplemental Income and Loss for reporting.
Capital gains taxes. If you sell an investment property for more than you paid for it, you'll owe capital gains tax. While homeowners can exclude up to $250,000 of the gain ($500,000 if you're married filing jointly), real estate investors don't generally qualify for the exclusion because properties aren't their primary residences.
The sale will trigger short-term capital gains if you held the property for less than a year -- for example, if you flipped a house. If you hold it for longer, it's taxed at the lower, long-term rate (see the above chart for details).
Deductions for real estate investors
As a real estate investor, you pay taxes on real property, income, and capital gains. But several deductions can help lower your tax bill.
If you own an investment property, you can deduct more expenses than you can as a homeowner. In fact, you can deduct all legitimate expenses related to your property, including:
- Mortgage interest.
- Property taxes.
- Operating expenses.
- Maintenance and repairs.
You claim these deductions during the same year you spend the money and report them (and any rental income) on your Schedule E tax form.
You can also deduct the cost of buying and improving the property, but it works differently. Rather than taking one huge deduction when you acquire the property, you depreciate the costs across the "useful life" of the property.
According to the IRS, you can depreciate a rental property if it meets four conditions:
- You own the property.
- You use it in your business or income-producing activity.
- The property has a determinable useful life. It must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
- The property is expected to last at least one year.
You can't depreciate a property that you put in service and sell (or remove from service) during the same year. And because land doesn't wear out, get used up, or become obsolete, you can't depreciate it. That means you have to figure out the value of the land and subtract it from your cost basis to determine how much you can depreciate.
Any property put into service today will spread depreciation over 27.5 years. That comes out to 3.636% of the cost basis each year.
You continue to depreciate for up to 27.5 years or until you retire the property from service -- whichever comes first.
Depreciation recapture on rental property
If you sell a rental property, depreciation will play a role in how much tax you owe. That's because depreciation deductions lower your cost basis in the property, so they ultimately determine your gain or loss when you sell.
The IRS remembers the depreciation deductions you took -- and they'll want some of that money back. That's what depreciation recapture does. It's based on your ordinary income tax rate and capped at 25%. It applies to the part of the gain that can be attributed to the depreciation deductions you've already taken. You'll use Form 4797, Sales of Business Property, to report depreciation recapture.