Many people are afraid to invest in the stock market because of its volatility. I can’t say I blame them. Sometimes that is one roller coaster that you just can’t get off quick enough. Many of these people turn to real estate as an investment. There are many ways to invest in real estate and make money at it. We are going to discuss a few here and focus on the area of residential real estate (there are a few other areas of real estate to invest in such as vacant land, commercial, self-directed IRAs and REITs).
First, you can buy property to flip it. This is where you acquire a piece of real estate at below fair market value (FMV), put some money into to fix it up, and then turn around to sell it (usually with the goal of selling it within six months of purchasing it). If you can purchase the property at the right price and it has the right things wrong with it, this is a great way to make a relatively quick buck. Keep in mind that due to this being a short-term investment (holding the investment for under a year), any gain realized is a short-term capital gain. The big issue here is that the gain is subject to your ordinary income tax rate. So if you are in the 25 percent income tax bracket, then your flip gain is now taxed at 25 percent.
One way to reduce the tax burden is to hold the property for a year and a day, and now it becomes a long-term capital gain subject to a 15 percent or 20 percent tax rate (it depends on your adjusted gross income). Another way to reduce taxes is to live in it as your primary residence for two years then sell it. You can fix it up while you live in it and when you sell it, the gain (up to $250,000 for a single individual or $500,000 for married filing joint) would be excluded from any tax.
You can do this method once every two years. But be sure to keep track of the cost of the items you pay for during the fix-up process.
Now should you be an investor who flips a lot of properties during the course of the year (let’s say greater than five, although this is a facts and circumstances test and five is not the magic number), you could be considered a dealer in real estate.
Why does this matter? Because your gains are subject to your ordinary income tax rate. This really only applies if you are holding property more than a year because as a dealer, you do not get the special 15 percent or 20 percent tax rate.
Again, if you have a gain and you are in the 28 percent tax bracket, you will pay taxes on that gain at 28 percent. One other drawback being a dealer, you do not get to spread out the gain over time in an installment sale. You have to report it at the date of sale.
The last way is to buy, hold and rent it. You buy a property, fix it up (if necessary) and then put it out for rent. Make sure you do your homework first and find out what the amount of monthly rent the property will be able to bear.
If you can generate a reasonable monthly rental income, you should be able to have the property cash flow positive (meaning you will not have to come out of pocket to cover monthly expenses).
Make sure you prepare a monthly budget to cover the expenses or at least know how much you have to fund each month. Deductible rental expenses include (but not limited to) the following items: advertising, auto and travel, cleaning, commission, insurance, professional fees, management fees, mortgage interest, HOA dues, lawn maintenance, pest control, repairs, supplies, taxes, and utilities.
In addition, you get to expense an amount for depreciation. This is expensing a small fraction of the original purchase of the house (but not land). Keep in mind that if you convert your primary residence and you are now going to rent it out more than a year after you purchased it, you need to know the fair-market value of the property at the time you convert it to a rental so that you can use that for depreciation purposes. This can be more or less than your original purchase price depending on market conditions.
There are three big areas of caution when you have a rental property. First, if you use a management company, the fees they charge are deductible, but if you generate a loss on the property, it generates a passive loss that can only be netted with passive income. Second, if you manage the property yourself and you are not a real estate professional, the passive loss can be limited by your AGI or the most you can deduct is $25,000 annually.
Finally, remember that there will come a day when you want to sell the property. Assuming you have a gain on the sale, that gain can be partly generated due to the property having increased in value over time, but part of the gain is because you have been annually expensing through depreciation the cost of the property.
If you are planning on selling a property, especially if you have rented it over the years, please consult a tax professional or call our office to know what your potential tax liability may be.
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