There is no human invention more complex than the tax codes, and among the most complicated are the laws surrounding real estate investing. So, what follows is NOT to be considered legal advice — consult your attorney or tax accountant before making any decisions.
Well, now that the rear is covered, what considerations should the real estate investor keep in mind? Since laws vary between countries, and between states within the U.S., any general advice would be worthless. But here are some particulars that apply in many areas.
Many investors still believe they can purchase a residential home, not take up residence, make repairs and then sell it for substantial profit. And that's often true. But profits can be lowered by neglecting current tax law. The rule they're mis-remembering applied only to property used as a personal residence and, in the U.S., is no longer law.
In 1997 that rule was replaced by one that allowed for the tax-free sale of a personal property, occupied for two years or more. Investment income, whether from the sale of stocks or real estate is considered a capital gain. If the asset was held for a year or less it's a short-term gain, taxed at ordinary income tax rates — sometimes as high as 35 percent. Hold the asset for more than a year and any profit from sales is now a long term capital gain, taxed (usually) at 15 percent. So, one day more or less could make a 20 percent difference.
If you keep the property for at least 730 days, not necessarily sequentially, as a residence then you can pay no tax at all. That’s providing the money is reinvested in a home of equal or greater value. (There is a onetime exemption.)
For the investor not looking to occupy the property, there is an alternative — the 1031 exchange.
As long as you trade an investment or business property for another of “like kind”, you can defer any tax owed. “Like kind” is defined somewhat loosely. You can swap undeveloped land for developed land, a residential income property for commercial property, etc. The only restriction is the exchanged property has to be an income producing asset, not a personal one.
In a 1031 exchange, you have 45 days to identify up to three replacement properties and you must close within 180 days. You must also find a neutral intermediary, known as a “facilitator or accommodator”, to hold funds and keep records.
Keep in mind that a 1031 exchange is not tax avoidance. It’s merely tax deferral and it can't be used in conjunction with your personal residence. Consult with your tax advisor or attorney before taking advantage of this.
For married couples, tax law changes allow a profit of up to $500,000 on the sale of a personal residence, and $250,000 for singles, with no tax penalty.
Mortgage interest deductions continue to be one of the best tax write-offs, with loans up to $1 million qualifying, as well as any points or loan origination fees.
Finally, always keep accurate records and consult with professionals before making any investment decisions. This is especially true for those lucky enough to have inherited property, or those involved in estate sales and trusts. Their fees will be more than paid for by avoiding penalties and unexpected taxes.