Each Real Estate Investor Tax Classification has specific benefits and limitations. Nick Aiola with Aiola CPA takes us through some situations and breaks down the consequences for each.
Real Estate Investor Tax Classification
The IRS provides three general classes of real estate investor tax payer classifications; Passive, Active and Professional.
Passive: This applies to the investor who invest in other investors deals, ie a syndication. In this case, they provide the capital and receive income.
Active: This applies to investors who invest on the side ie; flip homes, landlord. This is not their primary occupation.
Professional: This applies to investors who spend more than 700 hours active in real estate; analyzing deals, talking with brokers, raising capital, working with contractors, tenants, etc.
Real Estate Income Tax Basics
The purchase price is your basis. The IRS recognizes that the structure has a useful life expectancy. For each year you hold the property a portion of the structure is depreciated. The amount of depreciation is subtracted from your basis, effectively reducing the value of building.
When a Mortgage is used to purchase the property, the interest paid is allowed to be written of as well.
Depreciation is one of the most effective tools available to real estate investors to reduce their taxable income. This is recognized as an expense that is subtracted from income when filing taxes. The amount of depreciation expense is based on the type of property, residential or commercial and if you or your sponsor has done a Cost Segregation Study..
For straight line depreciation, residential is based on 27.5 years and commercial is based on 39 years. When cost segregation is employed, a large portion of the building is broken into different class codes of personal property which have 5, to 15 year life expectancy. The life expectancy dictates the depreciation schedule applied.
Passive: For an investor with less than $100,000 annual ordinary income, they are able to take up to $25,000 above the income generated by the passive income generating property. This phases out as investor ordinary income grows to and in excess of $150,000. For losses that are not allowed in the tax year, they are carried forward for future tax years.
Active: Same as Passive.
Professional: This investor can claim all losses in the year they are recognized up to the amount of income received.
Sale of Property
The sale of property creates a taxable event. Depending on the length of time property was held will determine if the gains are ordinary or capital; less than or greater than one year.
When you have a gain, sell for more than your basis, you will owe taxes on the gain and depreciation you recaptured due to your gain.
The Depreciation recapture will be taxed at 25%, while the Capital Gains will be taxed at 15 – 20% depending on your taxable income.
For all investors; Passive, Active & Professional; Depreciation that was previously generated and has been carried forward, may be used to reduce the taxable income upon sale.
Each week I ask my guest, “What is the Biggest Risk Real Estate Investors face?”
BIGGEST RISK: I would say the biggest risk as a real estate investor would face would be failure to prepare. Not analyzing a deal or not understanding the scope of the work involved or understanding what kind of what level of commitment; time or cash it’s going to require from you is detrimental. We’ve seen that cripple people in the past.
For more go to: https://www.aiolacpa.com/