Real estate investment: What potential investors should know (2024)

There are several reasons why you may be interested in real estate investment. Along with diversifying your investment portfolio, investing in real estate can bring you income through appreciation or be a passive income source if you rent out your property. But what does all this mean for your taxes? What about reporting income from real estate? Keep reading as we outline the different types of real estate investments, what to know about real estate taxes, and the tax benefits of real estate investing.

What is real estate investment?

A real estate investment is real estate that generates income or is otherwise intended for investment purposes. This property is not regarded as a primary residence. Real estate investors often own multiple pieces of real estate to generate income and profits while keeping one piece as their primary residence. Investment real estate can be classified as commercial. This includes retail stores, office buildings, warehouses, etc. Real estate investments may also be residential, for example, single-family homes, duplexes, condos, etc. Whether you already own rental property or are just thinking of making your first investment, it’s crucial to understand how real estate taxes work. Generally, real investors need to know about taxes that relate to their rental income and taxes that relate to the eventual sale of the property.

Types of investors in real estate

There are two general ways to generate income from real estate investing. One is to hold the property for a certain period before selling it for more than you paid. The second way is to maintain property ownership, rent it out, and charge others for its use. Here’s a further breakdown of some frequently seen types of real estate investors.

Landlord

Becoming a landlord is a common way for people looking to get into real estate investment to enter the industry. This involves renting out a home, apartment, or other dwelling that you own to long-term tenants.

Short-term rental host

Another option is renting your property for short-term stays, typically through a service like Airbnb or VRBO. This is often considered a favorable option if you live in a city with a strong tourism economy. It is also one way to generate income from a property if you do not intend to occupy it full-time. Think, for example, a vacation property like a summer cabin that would otherwise sit vacant for multiple weeks or entire seasons.

Flipping houses

Flipping houses is becoming an increasingly popular way to earn income through real estate. For this type of real estate investment, you buy a home, invest money and labor into improving it, and then sell it for a substantial profit. The potential of a big payday is attractive, but getting into the house-flipping business requires a lot of forethought and experience.

Real estate investment trusts (REITs)

The above options all have one thing in common: the investor owns a piece of physical property directly used to make money. On the other hand, using a REIT is a different approach. Investing in a REIT involves pooling money from several investors to purchase ownership in a collection of real estate investments. Using a real estate investment trust lets investors get involved without risking too much. You’ll receive a 1099-DIV each tax year for this type of real estate investment.

How is rental income taxed?

Are you a seasoned landlord, a new short-term rental host, or just beginning to understand the process of real estate investing? Regardless, knowing how rental income is taxed is important. Rental income is taxed as ordinary income in accordance with your Internal Revenue Service (IRS) tax bracket. Rental income includes any payment you receive for the property use and occupation. In addition to the standard rent payments that may come to your mind, rental income also includes:

• Security deposits
• Advance rent payments
• Lease termination payments
• Lease with option to purchase
• Partial interest payments
• Tenant-paid owner expenses
• Property or services received in place of rent

How do you report rental income?

In most cases, you will report any rental income and related expenses on IRS Form 1040 and Schedule E (Form 1040), Supplemental Income and Losses. All income must be reported on your tax return, but general associated expenses can be deducted from your rental income. More on real estate deductions later. If your rental activity qualifies as a business, you will report the income on a business return.

What are real estate taxes?

When dealing with real estate investing, the kinds of taxes you’ll be responsible for will depend on whether you’re a property owner or just an investor. Here are some of the different types of taxes you might have to pay when investing in real estate. Learn more about small business tax forms.

Property taxes

State and local governments impose property taxes are usually based on the property’s assessed value. These rates vary greatly depending on where you live.

Net investment income tax (NIIT)

Investment income, such as dividends from a REIT, comes from some types of real estate investing. If you make this type of income from your investments, you likely will need to pay NIIT. Who is subject to this tax depends on filing status and MAGI. See the IRS rules for NIIT.

Real estate income tax

As mentioned earlier, rental income is considered passive income. It is taxed as regular income on your tax return.

Business income tax

Sometimes, renting real estate is classified as a trade or business if you provide more than basic services. For example, if you buy a property, turn it into a bed and breakfast, and provide extra services like linens, meals, or laundry, you’ll likely be classified as a business. This income will be reported on your business tax return.

Capital gains tax

If you plan to sell your real estate eventually, you may be subject to capital gains tax. You will have to pay capital gains tax if you have a capital gain. You will have a capital gain if you sell the property for more than its cost basis. Your tax rate will depend on whether the property qualifies as a short- or long-term capital gain. In most cases, you will report the capital gain on Schedule D (Form 1040), Capital Gains and Losses.

Individual income tax

If you’re only an investor and don’t own any property, you will be responsible for individual income tax on any gains earning interest income. This will be taxed at the same rate as your ordinary income.

Real estate property tax deductions

Rental income is taxed as ordinary income, but you can reduce that income and lower your tax bill by deducting related, allowable expenses. If you’re a rental property owner, you can generally deduct expenses for managing and maintaining your property, including payments you make related to the property for things like:

• Advertising
• Cleaning and maintenance
• Property management
• Property taxes
• Auto and travel expenses
• Insurance
• HOA fees
• Legal fees
• Utilities

Learn about other self-employed tax deductions.

Four tax benefits of real estate investment

Beyond diversification of your investments, investing in real estate comes with several tax benefits that can reduce your tax burden at tax time. Let’s look at four of these perks.

1. Rental property depreciation

One of the biggest tax perks of real estate investing is depreciation. Depreciation allows you to deduct the costs of buying and improving a rental property over its useful life. This lowers your taxable income as a result. You can depreciate your property if all the following are true:

• You are the owner of the property
• You use the property in your business or as an income-producing source (i.e., a rental)
• The property has a determinable useful life. This means that it’s something that wears out, decays, becomes obsolete or loses its value
• The property is expected to last at least one year

2. Take advantage of incentive programs

Incentive programs like 1031 exchanges and opportunity zones can provide major tax benefits. Using a 1031 exchange, you can defer taxes on real estate sales if you buy another investment property of equal or greater value than what you sold. You can take advantage of these exchanges as often as you’d like. Opportunity zones are another way for real estate investors to delay capital gains tax. If you sell real estate, you can delay these taxes by investing in properties in certain designated communities experiencing economic hardship.

3. Independent income without self-employed pitfalls

Rental income is not earned income. Therefore, it’s not subject to Social Security and Medicare taxes (FICA). If your real estate activity qualifies as a business, you’re considered self-employed. When this occurs, you will have to pay self-employment tax that represents the employee and employer portion of the FICA tax. But with real estate investing and nonbusiness real estate activity, you avoid the FICA tax, which can be a great benefit.

4. Tax advantage of capital gains tax

Again, capital gains tax comes from selling real estate at a profit. Short-term capital gains are profits from selling assets held for less than a year. Short-term capital gains receive no tax benefits because they’re considered regular income by the IRS. Long-term capital gains are profits from selling assets held for more than a year. They do result in tax benefits. Long-term capital gains are subject to a lower tax rate and aren’t counted as normal income. With long-term capital gains, your profit will fall into one of three tax brackets: 0%, 15%, and 20%. Depending on your filing status and Modified Adjusted Gross Income (MAGI), you may not have to pay any taxes on long-term capital gains.

Real estate investment: The bottom line

Getting involved in real estate investment is one way to diversify your portfolio and make extra income. But the process comes with many nuances. Work with a tax expert to be prepared for the tax implications of real estate investing. A Block Advisors small business certified tax professional can explain which scenarios and benefits apply to you. Owning a small business comes with many challenges and responsibilities before adding tax complexity. Block Advisors experts and services are here to help you year-round with your small business to-do list. Whether you need assistance with bookkeeping, payroll, small business tax preparation, incorporation, or beneficial owner reporting, we’ve got your back year-round.

Speak with a Block Advisors certified small business professional today.