Getting the Most of Your Investments: Real Estate Taxes and the Capital Gains Tax

Real estate property taxes are the taxes that the government charges property owners on “real property” each year through state and local governments. The real estate tax amount is levied according to the market or actual value of the property, and differs in percentage amounts around the United States. 

Like it or not, real estate taxes have to be paid.  If they go unpaid and are not kept current, it is possible for the local authority to foreclose on a property where the real estate tax has been delinquent. If you are a homeowner, it is possible to deduct real estate tax payments on your property, provided you have the option of itemized tax deductions. Deductable real estate taxes generally include any state or local taxes that are collected for general public welfare.  The IRS allows you to claim real estate tax on both the home you are living in and any other homes you may own. Currently, there is no limit to the number of homes you can claim deductions for or the amount of real estate taxes you can claim.

Property taxes can be paid under three different conditions:

In addition to the real estate tax, the capital gains tax is yet another form of tax that is paid on the sale of property.  Sounds like investing in real estate will leave you drowning in tax payments, right?  Not entirely.  Many people can defer paying the capital gains tax by completing a 1031 tax exchange.  While there are certain specifications that must be followed, understanding this tax code can make your assets suddenly become much more profitable.

Depending on the income of your property, your capital gains tax will vary.  While it’s usually commonplace for the IRS to snatch a healthy portion of your income investment, there are individuals who can qualify to not pay any tax on capital gains.  If you have lived in a residence for two of the five years before the sale date, you are eligible to exclude up to $250,000 of capital gains on your property (if you are married, you and your spouse may exclude up to $500,000).  Still, in order to qualify for this exclusion, you must complete a 1031 tax exchange. 

So, how can you calculate your capital gains?  When selling your home, add all occurred expenses, such as the purchase price, purchase costs, improvements, and selling costs.  Then, subtract any accumulated depreciation to figure out your cost basis amount.  Finally, subtract the cost basis from the selling price.  A positive total is a capital gain; a negative total is a capital loss.

Another way that a 1031 tax exchange is used is through the transfer of “like kind” investment properties.  This tax code allows investors to sell one piece of investment property and transfer the investment profits into another like kind property.  Basically, as the investor, you won’t receive a cash profit through the sale, but you will be exempt from paying capital gains taxes on the income of your sale.  This money will be transferred into the like kind investment.  However, this tax code can be taken even one step farther should you be forced to transfer the second investment property into your principal residence.  The transfer of like kind investment properties is covered under the 1031 tax exchange because the intention of the properties is for investment use only.  Should circumstances require you to turn your investment property into your primary residence, you may be able to be exempt from paying capital gains tax per the $250,000/$500,000 rule.

Still, these situations dabble a bit in the gray zone of 1031 tax exchanges.  The reason for turning your investment property into your primary residence must be legitimate and its legitimacy is up to the discretion of the IRS.  For example, if the property doesn’t rent or if your economic situation suddenly declines, you may decide that the best answer is to make the property your primary residence.  The IRS will ask for the facts of the decision and will likely want to see that you gave your investment property a fair trial before turning it into a primary residence. 

The word taxes has never been looked upon favorably.  When it comes to making investments, you obviously want to keep the profits in your own pockets.  Looking into 1031 tax exchanges can take a bit of work, but will also pay off in the long run.