Real Estate Taxes

Here’s what you need to know about real estate taxes before you buy (or sell) your next property.

Homeownership has its perks. You have a place to call home that you can decorate, remodel, and renovate as you choose. You build equity as you pay down your mortgage. You can also deduct certain expenses like mortgage interest and property taxes, which helps lower your tax bill for the year.

Real estate investors enjoy perks, too, but they go beyond the typical benefits of homeownership. Real estate investments can provide

  • a steady source of income,
  • loan paydown (your tenants cover your monthly loan payments),
  • equity-building,
  • cash flow,
  • portfolio diversification,
  • a hedge against inflation, and
  • tax benefits.

While nobody likes to pay taxes, homeowners and investors can take advantage of numerous tax breaks that reduce the amount they owe.

Because tax laws are complex and change periodically, you should work with a trusted tax accountant or CPA to ensure you get the most favorable tax treatment possible.

Still, it’s helpful to have at least a basic understanding of what you’re getting into tax-wise when you own or invest in property. Here’s an introduction to real estate taxes to help you get started.

Taxes and deductions for property owners

If you own real estate, you're on the hook for two primary types of housing-related taxes:

Property taxes

If you own a house, you’re probably familiar with property taxes. Your local government collects real estate taxes to help pay for services and projects that benefit the community -- emergency services, libraries, schools, roads, and the like.

You pay these taxes directly to your local tax assessor each year or as part of your monthly mortgage payment. Property taxes are based on the assessed value of your land and any buildings on it.

As long as you own the property, you continue to pay real estate taxes. You don’t stop when you pay off your mortgage, nor do you stop if you no longer use the home as your primary residence. If the property is in your name, you’re on the hook for the taxes.

Of course, property taxes change periodically, and your bill could be higher or lower than in previous years. This can happen when your home is reassessed or when your local government updates the tax rate (either up or down).

How can I lower my property tax bill?

Estimates show that 30%–60% of properties in the U.S. are over-assessed, which means you could be paying too much in taxes. If you think the assessor made a mistake, you can appeal your home’s assessed value.

You may also be able to lower your tax bill by taking advantage of programs that offer tax deductions and exemptions for seniors,

  • veterans and their surviving spouses,
  • people with disabilities, and
  • people who own agricultural land.

Also, most states offer homestead tax breaks that exempt part of your home’s value from property taxes.

One other option: Depending on where you live, you may be eligible for a discount if you pay your tax bill early. Check with your local tax office to learn about any tax deductions, exemptions, and discounts available in your area.

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Capital gains taxes

Another type of tax that homeowners and investors might owe is capital gains tax. You trigger this tax if the proceeds from selling your property are greater than its cost basis.

Your net proceeds are equal to the price you sold the property for minus any costs associated with the sale. The cost basis is the sum of

  • the price you paid for the property,
  • costs associated with buying the property (mortgage application fee, appraisal fee, home inspection fees, transfer taxes, etc.), and
  • the cost of any major improvements (replacing the roof, adding a bathroom, etc.).

Capital gains tax applies only to the gain (i.e., the profit) -- not the selling price or the net proceeds. To figure out the gain, deduct the cost basis from the net proceeds. If it's a negative number, you've incurred a loss. If it's a positive number, it's a gain and you may owe capital gains tax.

Capital gains tax exclusions

Most homeowners can exclude up to $250,000 ($500,000 if you're married filing jointly) of capital gains from the sale of their primary home. But to do so,

  • the house must be your primary residence,
  • you must have lived in the house for at least two of the last five years (the years don't have to be consecutive), and
  • you must have owned the house for at least two of the last five years.

Also, you might be able to exclude some of the gains if you sold the house due to

  • job relocation,
  • medical or health reasons, or
  • an unforeseen circumstance such as death, divorce, or a natural disaster (and you can no longer afford your current home).

Short-term and long-term capital gains tax rates

If you have gains that exceed the exclusion or you don't qualify for one, you'll report the gain on Schedule D (Form 1040), Capital Gains and Losses. Different tax rates apply depending on how long you owned the property:

  • It's a short-term gain if you owned the house for less than a year. These gains are taxed as ordinary income.
  • It's a long-term gain if you owned the house for more than a year. These generally receive a more favorable tax rate.

Here's a rundown of capital gains tax rates for 2019:

Tax Rate Single Married filing jointly Head of household Married filing separately
10% %0 to $9,700 $0 to $19,400 $0 to $13,850 $0 to $9,700
12% $9,701 to $39,475 $19,401 to $78,950 $13,851 to $52,850 $9,701 to $39,475
22% $39,476 to $84,200 $78,951 to $168,400 $52,851 to $84,200 $39,476 to $84,200
24% $84,201 to $160,725 $168,401 to $321,450 $84,201 to $160,700 $84,201 to $160,725
32% $160,726 to $204,100 $321,451 to $408,200 $160,701 to $204,100 $160,726 to $204,100
35% $204,101 to $510,300 $408,201 to $612,350 $204,101 to $510,300 $204,101 to $306,175
37% $510,301 or more $612,351 or more $510,301 or more $306,176 or more

Short-term rates (taxed as ordinary income). Data source: Internal Revenue Service.

Tax Rate Single Married filing jointly Head of household Married filing separately
0% $0 to $39,375 $0 to $78,750 $0 to $52,570 $0 to $39,375
15% $39,376 to $434,550 $78,751 to $488,850 $52,571 to $461,700 $39,376 to $244,425
20% $434,551 or more $488,851 or more $461,701 or more $244,426 or more

Long-term capital gains rates. Data source: Internal Revenue Service.

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,
  • insurance,
  • operating expenses, and
  • 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.

Depreciation

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.

IRS form 4797
Image Source: Internal Revenue Service

If you sell an investment property for a loss, depreciation recapture won't apply. As long as you owned the property for at least a year, the loss is considered a Section 1231 loss and you can use it to reduce your tax liability during the tax year.

Alternatively, you can carry back the loss to offset the previous two years of taxable income or carry it forward to offset future income for up to 20 years.

Qualified business income on rental property

One other deduction you may be eligible for is the Qualified Business Income (QBI) deduction. This deduction allows pass-through entities to deduct the lesser of these measures:

  • 20% of qualified business income plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
  • 20% of taxable income minus net capital gain.

While it's easy for many businesses to determine if they qualify for the deduction, it's been difficult to tell if it applies to rental real estate activities. It hinges on whether rental real estate is considered a trade or business.

IRS Notice 2019-07, however, created a safe harbor for rental real estate -- meaning rental property owners can take advantage of the deduction. To qualify, you must spend at least 250 hours a year managing the property and keep records of your activities. Vacation rentals and triple net leases aren't eligible.

1031 exchanges

These exchanges let you defer paying capital gains taxes when you sell an investment property.

A Section 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. In simple terms, you sell one property and buy another "like-kind" property with the proceeds. In the process, you can avoid paying capital gains tax.

To qualify as a 1031 exchange, you must meet three conditions with the sale:

  • The replacement must be like-kind. It's like-kind if it's real estate that's held for productive use in a trade or business or as an investment. Your primary residence wouldn't count.
  • You must pay tax on any "boot" in the year you make the exchange. Boot refers to the fair market value of non-like-kind cash, benefits, or other property that you receive in an exchange.
  • You must identify the replacement like-kind property within 45 days of selling the first property and you must acquire it within 180 days.

Although you defer capital gains taxes, you must still report a 1031 exchange on Form 8824, Like-Kind Exchanges.

How REITs are taxed

Another way to invest in real estate is through real estate investment trusts (REITs). These are specialized companies that let individuals pool their funds to invest in a collection of properties or other real estate assets.

If you own a REIT, you'll receive a 1099-DIV each year that shows the type and value of dividends you received. There are three types of dividends:

  1. Ordinary income dividends (shown in Box 1). These are usually taxed at your ordinary income tax rate.
  2. Capital gains distributions (shown in Box 2a). These are usually taxed as long-term gains, no matter how long you had money in the REIT.
  3. Return-of-capital payments (shown in Box 3). You don't pay tax on these dividends because they're considered a return of your capital.

Opportunity zones

Opportunity zones were created by the 2017 Tax Cuts and Jobs Act. They're intended to spur economic development and create jobs in distressed communities by providing tax benefits to people who invest money into these areas.

There are three tax incentives for investing in a Qualified Opportunity Fund (QOF):

  1. Capital gains deferral. You can defer tax on prior gains if you invest them in a QOF. You can defer until the QOF is sold or exchanged, or Dec. 31, 2026, whichever comes first.
  2. Capital gains reduction. If capital gains are held in a QOF for at least five years, your basis in the original investment increases by 10%. That jumps to 15% if you hold the investment for at least seven years.
  3. Capital gains exclusion. Capital gains from the QOF are tax-free if you hold the QOF for at least 10 years.

Read our guide to opportunity zones for more information

Opportunity Zones Map
Image source: Economic Innovation Group

Find a good tax professional

While taxes for homeowners can be relatively simple, taxes for real estate investors are tricky. The taxes covered here are the ones you’ll likely encounter as a real estate investor. Still, you may owe other taxes, and you may be eligible for other tax benefits, depending on your situation.

Tax laws are complicated and change periodically. Unless you're a real estate tax law rock star (few people are), you should plan on working with someone who is. Find a trusted tax accountant or CPA to guide you through the process of buying, operating, and selling investment property. That way, you'll get the best tax treatment possible and avoid any surprises at tax time.

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