Level 22: Income Tax in Real Estate - Chapter 2: Capital Gains and Tax Shelters

What Are Capital Assets Anyway?

A capital asset is a piece of property with a useful life longer than a year that isn't intended for sale in the regular course of a business's operation (in other words, not inventory). For example, if you buy 500 pounds of cheese to sell at a cheese store, that's not a capital asset. That's your inventory. But if you buy 500 pounds of cheese as an investment, then that's a capital asset (do not invest in cheese).

NIIT Example

A married couple filing jointly made $300,000 in regular (active) income last year. They also had $600,000 in capital gains from selling their primary residence, which they have lived in for the last six years. How much NIIT do they owe? Since they qualify for the full capital gains exemption, they have $600,000 - $500,000 = $100,000 in taxable capital gains. They only pay NIIT on the qualifying income of $100,000. The tax is 3.8%, so... $100,000 x 0.038 = $3,800 in NIIT, on top of the capital gains tax they will have to pay (which will depend on their income bracket) on the $100,000. Hey, nobody said being wealthy was going to be easy!

But First: Types of Income

But before we can talk about ways to avoid paying your taxes — oops, I mean ways to shelter your investment's capital gains — we need to talk about different kinds of income and how the IRS classifies them. There are three types of income, and when you do your taxes, you have to separate your money into these three buckets.

Taxes on Capital Gains

Capital gain refers to the profit received from selling a capital asset. Conversely, capital loss refers to the loss incurred from selling a capital asset. Capital assets include all of the taxpayer's tangible property, such as real estate, investment properties, and equipment, but do not include property that is held for regular sale to consumers.

How Partial Exemptions Work

If unforeseen circumstances force you to move before you've been in a home for two years, you are eligible for a prorated capital gains exemption. The equation to determine the prorated amount is: months in home ÷ 24 x exemption amount ($250,000 for a single person or $500,000 for a married couple) For example, if a couple is in a home for 12 months but had to move because of a job loss, they would be eligible for $250,000 in capital gains tax exemption (12 ÷ 24 x $500,000).

1031 Exchanges: The Boot

Maybe it seems like anything can be traded for anything else, as long as we're not talking about livestock of different sexes. It's true that the definition of "like-kind" is pretty loose. That's tax law for ya! But like-kind exchanges aren't just for real estate. Many kinds of property can be traded in this way: cars, planes, office furniture, Funko Pops. If you're exchanging real property for personal property, or two kinds of real property that don't meet the rules for being "like-kind," you'll include a boot to even out the exchange.

What Qualifies for the Pass-Through Deduction?

Qualified Business Income (QBI) from real estate investments would qualify for this deduction. Real estate agent commission income should qualify, too. There are restrictions on what kind of businesses can take the deduction at adjusted gross incomes north of $157,000 — specified service trades or businesses need not apply — but honestly if you're making that much money, you shouldn't be getting tax advice from a robot anyway.

Calculating Realized Gain/Loss

To find the realized gain or loss, subtract the cost of selling the property from the sale price of the property. Keep in mind that if the sale price of the property is higher than the cost of sale, there will be a gain and vice versa.

1031 Exchanges: The Qualifications of the Intermediary

A qualified intermediary can't be the exchanging party's: Accountant Lawyer Investment broker Employee Family member So, who is this mysterious intermediary? It's up to you, the agent, to help your client find someone trustworthy. They aren't required to be bonded, certified, audited, licensed, or insured, and you're essentially handing them a bag of cash, so choose carefully!

1031 Exchanges: The Reverse Exchange

A reverse 1031 exchange is just like a regular 1031 exchange except backward. Like this: egnahcxe 1301. Juuuust kidding. Listen, it's the tax level of the course. We've got to get our fun in where we can, right? Actually, a reverse 1031 exchange is just a like-kind exchange where the investor identifies and purchases the replacement property before they sell the property being exchanged. Bing-bang-boom. Reverse exchangeroo.

Showing Your Appreciation

Capital gains happen as the result of appreciation, or the increase in value of a property. At its most simple, a capital gain is just the extra money created when property appreciates. Which, if you are a homeowner, you definitely do appreciate. 😉

Exceptions to the 2-Year Requirement

Exceptions to the two-year use requirement also include the following: Property acquired in rollover transactions, which are transfers of funds to investments of the same type, used to defer the payment of taxes (i.e., 1031 exchanges) Property transferred by a spouse Property owned by a spouse, former spouse, or deceased spouse Owners who have received care from a nursing home Exceptions may only be made once every two years, again unless the sale is the result of a change in health or employment. When homes are sold for less than $250,000 (or $500,000 for joint filers) above the original purchase price, the owners do not have to file an information return reporting the sale of their principal residence.

Calculating Net Operating Income (NOI)

First of all, you need to figure out your net operating income (NOI). Your NOI is your total income minus expenses. What counts as an expense? Here is a non-exhaustive list: Money spent on maintenance or repairs Property taxes Marketing expenses Utilities Legal fees Insurance Bookkeeper or accountant fees Property management fees Office expenses Snacks (Do not actually deduct money for snacks.)

When Real Estate Isn't Passive Income

For money made from an investment property to qualify as active income, you have to actively manage it (makes sense, right?). The IRS defines this as "material participation." What constitutes "material participation" depends to some extent on how clever your CPA is, but generally it's the difference between personally landlording (finding tenants, scheduling repairs, managing issues with the property) and hiring a management company to landlord while you sit back and collect the checks.

Capital Gains Exclusion Example

Let's look at an example. Harry and Louis are a married couple who bought their primary residence three years ago for $650,000. They just got a sweet all-cash offer for $900,000. Their closing costs when they bought the house were $50,000. The cost of the sale was only $10,000. They've both lived in the home for the last three years. How much capital gain will they pay tax on? Their adjusted basis in the home is $650,000 + $50,000 = $700,000. Their realized gain is $900,000 - $10,000 = $890,000. $890,000 - $700,000 = $190,000 in capital gains. Since both spouses owned and lived in the home as a primary residence for at least two years, they qualify for the full $500,000 exclusion. $190,000 is well under the $500,000 exemption, so they owe no taxes. Whew!

Calculating Income Taxes on Investment Property

Now! To calculate how much you actually have to pay in taxes, you just multiply your taxable income by your marginal tax rate. That tax rate might include NIIT and will depend on the rest of your income, so encourage clients to talk to a tax pro to get real numbers. Also, the TCJA added a 20% deduction for "pass-through income" — rental income may qualify for this deduction.

But What About the Investors?

Remember that the capital gains exemption is only available for people selling their primary residence (Remember? You remember). But what about investors? Are they supposed to just sit there and pay their taxes? No, no. There are other ways to avoid having to pay capital gains taxes, at least for a little while. These are known as tax shelters. You've already learned a bit about tax shelters in other levels, but as a reminder: A tax shelter is any method used to reduce taxable income, thereby reducing the amount of tax paid to a government.

Holding Period Drama

Short-term capital gains are taxed differently from long-term capital gains. How long an asset has to be held to qualify as "long-term" holding has changed over the years, and is a politically contentious subject. Some lawmakers consider the tax break for long-term capital gains to be a way for the wealthy to get out of paying their fair share, while others see it as a way of compensating for inflation.

Capital Gains Exclusion Eligibility

Taxpayers must meet ownership and use requirements to be eligible for the exclusion. The taxpayer must have owned and occupied the home as a principal residence for at least two of the five years preceding the sale. The two years may be an aggregate amount of time, and need not be continuous. For married couples, both spouses must have occupied the residence for at least two years out of the prior five years. Only one spouse needs to have owned the property for at least two out of five years. Also, neither spouse can have used a capital gains exemption in the past two years (they are reusable every two years).

1031 Exchanges: The Three-Property Rule

The three-property rule says that the person exchanging their property can identify no more than three properties as replacement properties with no regard for the fair market value of the properties. So with the three-property rule, the exchange is limited by the amount of properties.

Capital Gains Exclusion Eligibility Exemptions

The two-year requirement (and other residency requirements) can be modified or waived for unforeseen circumstances that force a homeowner to sell, including: Death of a spouse Loss of a job Change in employment that requires a move of at least 50 miles Health concerns (specifically, needing to move to provide the diagnosis, cure, or treatment of a disease, illness, or injury) Divorce Multiple births (👶👶👶) Eminent domain Disaster

Home Office Capital Gain Exclusion

Though the home office tax deduction was eliminated for anybody but self-employed people in the Tax Cuts and Jobs Act of 2017, there may still be homeowners out there who have taken the home office deduction in the past. When you take a home office deduction, you are essentially converting part of your primary residence to a place of business and therefore it must be depreciated like any other business (whether or not you actually claim that depreciation on your taxes). When the taxpayer sells the home, the converted portion is subject to the 25% depreciation recapture tax (and is not eligible for the capital gains exemption). Taxpayers who used the newer "simplified" home office deduction, however, are not subject to depreciation.

1031 Exchanges: Identifying a Property

When the IRS talks about properties of "like kind," they just mean investment properties. They don't actually have to be that similar. Here are some things to keep in mind: You can't exchange real property for personal property without a boot. A boot is non-like-kind property that evens out the exchange, and is not tax-deferred. You can't exchange a primary residence or vacation home (so, a non-income-producing property). You can't exchange a flipped property unless you've used it as an income-producing property (rented it) before selling. You can't exchange livestock of different sexes (I know, there goes that plan). You can't exchange U.S. property for non-U.S. property.

Short-Term Capital Gains

Short-term capital gains are taxed as normal income, according to federal income tax rates. This means that in most cases, short-term gains are taxed at a much higher rate than long-term gains.

Calculating the Taxable Income on Investment Properties

So okay, you've figured out whether your investment property income counts as active or passive income, but you still need to know the most important thing: how much? Here's the formula you'd use to figure out the income from your income-producing properties for tax purposes: Taxable income = Net operating income - Mortgage interest - Annual depreciation allowance - Carryover losses That's super obvious, so let's move on. Just kidding! It's complicated stuff. Let's dig into it. ➡️

1031 Rules Recap

So, essentially, you've got three options for choosing replacement properties. Either: You limit the properties by total value, which can't be more than 200% of the original property's value (200% Rule). You limit the properties by number of properties, which can't be more than three (Three-Property Rule). You limit the properties by what you know you can close on, which is 95% of the total value of the initially-identified properties (95% Rule). Totally intuitive, right? Nothing over-complicated here. Sorry, Mustafa, them's the rules.

1031 Exchanges: What a Qualified Intermediary Does

A qualified intermediary in a 1031 exchange: Prepares all the necessary paperwork and documentation Gets, holds, and distributes the money for the exchange Resolves any title issues for the investor Makes sure all parties are in compliance with treasury regulations If anybody but the qualified intermediary handles the money or stuff involved, BAM, capital gains tax kicks in.

1031 Exchanges

According to Section 1031 of the US Internal Revenue Code (26 U.S.C. §1031), the exchange of certain types of investment properties may defer the recognition of capital gains or losses upon sale, therefore deferring when any capital gains taxes need to be paid. Allow me to elaborate a bit on 1031 exchanges, Mustafa. A 1031 exchange lets an investor sell a property, reinvest the proceeds in a brand new property, and defer all capital gain taxes. It's called a like-kind exchange, because you're exchanging a property for a property (or properties) like it. The difficulty with a 1031 is that you have a limited period of time (45 days) in which to identify the new property and close (within 180 days). To be fully clear, IRC Section 1031 (a)(1) says: No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.

The Three Types of Income

Active income is earnings (including wages, salaries, commissions, and bonuses) from a trade or business where the taxpayer is an active participant. In other words, money you earn by doing stuff. For most people, active income will make up most or all of their income. Passive income is earnings from any trade, business, or income-producing activity in which the taxpayer doesn't actively participate. Most real estate investments will produce passive income. Portfolio income is income from dividends, stocks, bonds, and royalties received from properties held for investment.

Calculating Capital Gains on Investment Property

Calculating the capital gain (or loss) on an investment property is really similar to calculating capital gain for a primary residence. The main difference is that you have to remember to deduct any claimed depreciation from your adjusted basis. It would look like this: Adjusted basis = Basis + Cost of improvements + Qualified closing costs - Realized depreciation Capital gain or loss = [Sale price - Cost of sale] - Adjusted basis Example time, ladies and gents. Lando is buying up investment properties in Cloud City. He snags an old building for $500,000 and puts $200,000 worth of work into it. His closing costs were $10,000. He rents it out to tenants for five years, claiming $20,654.55 per year in depreciation. (We'll talk later about why that's the number — I know you are so excited to learn about depreciation, Mustafa, but YOU'LL JUST HAVE TO WAIT.) Five years on, he sells it for $1.3 million. It costs him $100,000 to sell it, including a 6% commission (cha-ching!) and closing costs. To calculate his capital gains, we need to first find his adjusted basis. Note that we have to multiply $20,654.55 by 5 because he rented out the property for 5 years. $500,000 + $200,000 + $10,000 - $103,272.75 (which is $20,654.55 x 5) and get $606,727.25. Then we need to plug the adjusted basis into the formula for capital gain: ($1,300,000 - $100,000) - $606,727.25 = $593,272.70 The capital gain is therefore $593,272.70. Wowee, that's a lotta gain! Lando's gotta get a tax shelter. (Though he can subtract any leftover passive losses at the time of sale. You know, just FYI.)

Chapter 2 Key Terms

Here are some handy key terms you'll need to know for this chapter: ✏️ appreciation: the increase in value of a property ✏️ capital loss: the loss incurred by selling a capital asset ✏️ adjusted basis: the basis plus the cost of any improvements, minus the amount of depreciation ✏️ basis: the buyer's initial cost of real estate ✏️ tax shelter: any method used to reduce taxable income, thereby reducing the amount of tax paid to a government ✏️ debt service: the amount of money needed for a specific time period in order to cover the payment of principal and interest portions on a loan ✏️ cash flow: refers to the cash that an investment generates after accounting for the operating expenses, debt service, and taxes associated with the enterprise ✏️ active income: earnings (including wages, salaries, commissions, and bonuses) from a trade or business where the taxpayer is an active participant ✏️ passive income: earnings from any trade, business, or income-producing activity in which the taxpayer doesn't actively participate ✏️ tax-deferred exchange: the tax-deferred sale or exchange of one investment property for another similar one, also called a like-kind exchange or 1031 exchange ✏️ boot: extra, non-like-kind property included in a tax-deferred exchange to make up a pricing disparity in the exchange; is not tax-deferred

1031 Exchanges: The No-No List

Here are the kinds of properties that can't go through a 1031 exchange: Personal residences Properties owned by dealers Properties owned by related parties Properties located outside of the U.S. Properties owned by someone who has done a 1031 exchange in the last two years

Rules for a 1031 Exchange

Here are the rules for a 1031 exchange: The new property (or properties) must be identified in less than 45 days from closing on the sale of the old property. The new closing must happen less than 180 days from the sale of the original property or the tax return due date, whichever is sooner. The properties must be of "like kind." Any cash has to go through a qualified intermediary. Personal property, inventory, partnership interests, and securities are not eligible. Those deadlines are firm, Mustafa. The IRS is not here to play around with like-kind exchanges. The IRS does not like jokes. Do not anger the IRS.

1031 Exchanges: The 200% Rule

In fact, you can even trade one property for multiple properties. You just have to meet one of three selection criteria. The first is called the 200% rule. It states that the aggregate fair market value of the replacement properties can't exceed 200% of the original property. So with the 200% rule, the exchange is limited by the cost of the properties.

Installment Sales

Installment sales work like any kind of layaway plan (are you old enough to remember layaway, Mustafa?). The buyer pays the seller for the property in pre-determined chunks for a pre-determined length of time, and the seller holds the title until the property has been fully paid for. In an installment sale, the seller only pays taxes on the money they have already received, in the year that they receive it.

Recaptured Depreciation (Sad Trombone)

Lando's tax liability doesn't stop there, either. In addition to what he owes on his capital gains, he has to pay a 25% tax on what's called recaptured depreciation. We'll go into detail about depreciation later (STOP HOUNDING ME ABOUT DEPRECIATION! ALL IN GOOD TIME!), but essentially it's a way for owners of investment properties to spread the loss of value caused by aging over the course of either 27.5 or 39 years. When you depreciate a property, you take the depreciation allowance as a tax deduction every year, essentially putting off some tax liability until you sell. And those taxes are about to come due. 🎵cue sinister music🎵 When Lando sells his Cloud City complex, he'll pay a 25% recaptured depreciation tax on all of the depreciation he claimed over the course of the holding period (which is tax-speak for the time he owned the property). If you remember from a few screens back, Lando depreciated his property $103,272.75 over five years. So at sale time, he's going to owe $25,818.19 to the Empire's tax assessor. Sad trombone.

Taxable Income for Investment Properties: Example

Let's look at an example. Pretend you have a cute little apartment building on a tree-lined block in Brooklyn. It produces $200,000 a year in NOI. $10,000 of your gross income for this year is set aside to do repairs and replace the boiler when it finally croaks. That is your reserves for replacement. Hold up, Mustafa. I have a quick note for you about replacement reserves. Different states and industries treat them differently when calculating taxable income. According to the American Property Tax Counsel, it is recommended that investors act in accordance with industry standards when deciding how to handle replacement reserves. You paid $40,000 in mortgage interest, your annual depreciation allowance is $15,000 (we'll get into how depreciation works later), and you have a carryover loss of $5,000. (Remember, you can only deduct passive losses against passive income. The rest must be carried over.) $200,000 - $40,000 - $15,000 - $5,000 = $140,000. That's your taxable income, baby. 💰

Capital Gains

Let's start off by taking a deeper dive into capital gains and the capital gains exemption. As you hopefully remember, capital gains exemptions are a benefit enjoyed by homeowners who sell their primary residence. The capital gains exemption is also called a Section 121 exclusion after the part of the tax code that it resides in, or the $250,000/$500,000 rule, for the amount that taxpayers can exempt.

Another Capital Gains Exclusion Example

Liam is a single gentleman who has never settled down with a partner, though he did make a commitment to a West Village condo thirteen years ago. He paid $200,000 (can you believe the West Village was ever that cheap?!), plus another $10,000 in closing costs. The condo was his primary residence for seven of the years he owned it (he spent some time in Berlin), including three of the last five. He's finally decided to pack it up and move to Europe for good. He was delighted to find that his adorable, exposed-brick one-and-a-half bedroom with a balcony is now worth $1,300,000 (it's to die for). It cost him $90,000 to sell the place. How much capital gain will he pay taxes on? His adjusted basis is $200,000 + $10,000 = $210,000. His realized gain is $1,300,000 - $90,000 = $1,210,000. $1,210,000 - $210,000 = $1,000,000 in capital gains. He gets a $250,000 exclusion, so he has $1,000,000 - $250,000 = $750,000 in taxable gain. Ouch.

Long-Term Capital Gains

Long-term capital gains are currently taxed at 0%, 15%, 20%, 25%, or a combination of these rates, based on the amount of other income the taxpayer earns. The more money you make, the more capital gains tax you pay. Sometimes taxpayers also have to pay an additional 3.8% net investment income tax (NIIT). New York State and New York City also have their own capital gains taxes that top out at 8.82% and 3.876%. Luckily, with the big exemptions available to people selling a primary residence, most non-investors won't have to worry about paying capital gains tax. The 25% rate applies to depreciated properties, which are discussed later in this level. The tax rate is higher here because investors received previous tax deductions from depreciating a property over its useful life.

Math Workshop: Your House

Now it's your turn to give it a try. Let's pretend you bought a nice house in Beacon five years ago for $525,000. You sold it this year for a cool $700,000 (nice investment, Mustafa!). Here are some details you need to know for this workshop: You're currently unattached and happy. Your adjusted basis is $550,000. Your realized gain is $664,000 (which, just as a reminder, is your sale price - the cost of sale) This home was your primary residence for the last five years. You can't wait to take the profit from the sale and travel somewhere you've always wanted to go. Hey — you deserve it. Your House: Explanation Answer: You paid capital gains tax on $0. Explanation: We used the formula Capital gain = Realized gain - Adjusted basis to find your capital gain. Since the realized gain is already given, no need to calculate it! $664,000 - $550,000 = $114,000 You qualified for a $250,000 capital gains tax exemption because the home was your primary residence for two of the last five years. $250,000 is more than $114,000, so your profits were tax-free. Possible errors: You might have forgotten that homeowners qualify for a capital gains exemption on their primary residence, and thought you had to pay tax on the entire profit. But no way! The Taxpayer Relief Act of 1997 took care of that for you.

1031 Exchanges: The Qualified Intermediary

Okay, so in this extremely simple and not at all overly complicated 1031 exchange process, in addition to finding the right kind of replacement properties, the exchanging party also needs to hire a qualified intermediary. The qualified intermediary carries out the exchange for the investor, since they can't just buy and sell the properties for cash, they have to exchange them. If anyone but the qualified intermediary touches the cash, the 1031 exchange is disqualified. It's kind of like when you were six and you pestered your siblings by holding your finger inches from their face while singing, "I'm not touching youuuu!" We all did that, right?

Tax-Deferred Exchanges

One way Lando could temporarily reduce his tax liability is through a tax shelter called a tax-deferred exchange. Also known as a 1031 exchange or a like-kind exchange, a tax-deferred exchange is the tax-deferred sale or exchange of one investment property for another similar one. It's a totally-legal-yet-kinda sneaky way to avoid paying capital gains taxes when you sell an investment property. You'll still have to pay eventually. Well, unless you die first, I guess. In that case, the IRS can pry those bucks from your cold dead hands. Ahem. Let's get into the details, shall we?

What Doesn't Qualify for a Pass-Through Deduction?

Only QBI can be considered for the deduction. QBI is generally figured as total profits minus regular deductions. The following are not part of a business's QBI: Short-term capital gain or loss Long-term capital gain or loss Dividend income Interest income Wages paid to s-corp shareholders Guaranteed payments to partners in partnerships or LLCs Income earned outside the U.S.

Pass-Through Income: What Even Is It?

Pass-through income is qualified business income (QBI) earned by a person or company doing business as a sole proprietorship, S-corp, LLC, or partnership. Basically, any business entity that is not a C-corp. C-corps (the corporations that are people™) pay tax on their income twice, first at the entity level, then again at the shareholder level. Pass-through income is income that "passes through" having to pay a corporate-level tax, and is claimed by the owners or shareholders directly on their tax returns. The TCJA reduced the highest corporate tax bracket from 48% to 36.8%, so keep a proportionally favorable tax position for non-C-corps (who tend to be small businesses), the TCJA also introduced a 20% tax deduction for pass-through income.

Calculating a Capital Loss

Sadly, Mustafa, life isn't all rainbows and cupcakes and capital gains. Sometimes, you take a capital loss. Chin up, champ, the good news is that you may be able to write off some of that loss at tax time, or use it to offset a non-exempt capital gain. How do you calculate the amount of capital loss? Essentially the same way you calculate a capital gain, only you get a negative number. 😢

1031 Exchanges: The 95% Rule

The 95% rule says the person exchanging property can identify (in the first 45 days) as many replacement properties as they want and they can be worth as much as they want, as long as (by 180 days) they've closed on properties with at least 95% of the value of all of the identified properties. So the 95% limits the exchange by neither cost nor amount of properties, as long as you actually get what you say you're going to get (or 95% of it).

Calculating Capital Gain for a Primary Residence

The IRS imposes a tax on all forms of capital gains. In real estate, capital gain is calculated using the property's adjusted basis. To find the adjusted basis for a primary residence, you take the property's sale price, or basis, and add the cost of any improvements and certain closing costs and subtract your realized depreciation. To find the amount of capital gain or loss, subtract the adjusted basis from the realized gain/loss. Let's look at an example. Say Lando buys a primary residence in Cloud City for $500,000. That $500,000 is his basis. His closing costs (transfer taxes, title insurance, and legal fees) are $10,000. He puts in a new garage, and that costs him $30,000. We add that to the $500,000 basis to get a $540,000 adjusted basis. In a few years, he sells his house for $600,000. It cost him $40,000 to sell the house, including a 6% agent fee. His realized gain is $600,000 - $40,000 = $560,000. To find his capital gain, subtract the $540,000 adjusted basis from the $560,000 realized gain to get $20,000 in capital gains. Lando pays no taxes because he has a $250,000 capital gains exemption. Nice.

Just Picking NIITs

The Net Investment Income Tax (NIIT) is a tax that was introduced as part of the Affordable Care Act legislation in 2013. Taxpayers who make more than $200,000 in adjusted gross income (for single filers) or $250,000 (for joint filers) pay the 3.8% NIIT on investment income from interests, dividends, rent and royalty income considered passive (more on that later), and short- and long-term capital gains, including any non-exempt gains from selling a primary residence. Taxpayers only pay NIIT on the eligible income above the $200,000/$250,000 limit. So for example, if single filer Jerome made $300,000 in adjusted gross income, and $25,000 of that is eligible investment income, he only pays the 3.8% NIIT on that $25,000. Plus, the money raised by NIIT goes toward making healthcare available to more people. That hopefully takes some of the sting out of paying it . 💉

1031 Exchanges: Give 'Em the Boot

The boot is a piece of non-like-kind property included in the exchange, and it's not tax-deferred. Here are three common kinds of boot (though there are many more examples): Cash boot: If a seller gives the buyer money to cover repairs (often called a concession in non-investment property), that is a cash boot, and the buyer will need to pay capital gains tax on it. Mortgage boot: If an investor takes over a mortgage worth less than the mortgage on the property they're exchanging, that's a mortgage boot and they pay taxes on the difference. Personal property boot: This could be like appliances or fixtures in a hotel or motel included in the exchange. That's right, the investor pays taxes on that too. Got it? Good. 👢👢👢

1031 Exchanges: What You Can Exchange

The following kinds of properties can be traded in a 1031 exchange: Commercial property Industrial property Income-producing residential property Vacant property held for investment purposes (dealers excluded) Hotels Motels Holiday Inns Leaseholds that bear lease terms greater than 30 years

Two Passive Income Exceptions

There are two exceptions when it comes to real estate and passive income. Real estate professionals (that's you!) can claim investment properties as active income as long as: More than half of the services they provide or business they involve materially participate in the trade of real property. They perform more than 750 hours of work in real estate over the tax year. The second exception is operators of small rental activities. If you only have an investment property or two but don't meet the qualifications for material participation, you can't put your rental income in your active income bucket. But you can deduct more losses than a larger land baron, if you "actively participate." To qualify for this exception, you need to own at least a 10% stake in the property. "Active participation" differs from "material participation" in that making management decisions qualifies as active participation, but material participation means actually spending time doing stuff. As long as your adjusted gross income is under $100,000, you can deduct up to $25,000 in passive losses per year. That deduction scales down by 50% with an adjusted gross income of $150,000 (in other words, $0.50 of every dollar you make over $100,000 is taken off the deduction, down to $12,500) and 0% beyond that.

Debt Service and Cash Flow

Two concepts to know when talking about investment income are debt service and cash flow. Debt service is the amount of money needed for a specific time period in order to cover the payment of principal and interest portions on a loan. If you were an individual, you'd probably just call this your "mortgage payment," but serious business-doers need serious business words. Cash flow refers to the cash that an investment generates after accounting for the operating expenses, debt service, and taxes associated with the enterprise. Cash flow can be calculated before or after taxes. Cash flow before taxes is an important number for real estate investors when determining whether or not a property is worth investing in. Since property is notoriously illiquid (to pull money out of the investment, you have to sell the whole thing), cash flow helps an investor see how much liquidity an investment will add to their business's finances. Gotta keep those finances hydrated. 💦 To figure cash flow before taxes, you deduct the debt service from the net operating income (we'll talk about how to get the net operating income in a bit).

Capital Gains Holding Period

Whether a capital gain is taxed as a short-term or long-term gain is determined by the length of time the property is held (the amount of time between the day a property is bought and the day it is sold). This is called the holding period. If the holding period was shorter than one year, the capital gain is short-term. If the holding period was greater than or equal to one year, the capital gain is considered a long-term gain.

Why Does It Matter?

Why does it matter what kind of income you're making? Because losses can only be deducted against income of the same classification. But what does that actually mean? Say you spent more than you made on your rental property one year. The difference between what you spent and what you made is called a loss. Losses on passive-income-producing properties are passive losses, and they can only be deducted against passive income. So, for example, if you lose $10,000 on your rental property, you can't just deduct that against what you owe Uncle Sam from your day job. The losses will carry forward into another tax year, so once you actually start making money on that dang investment property, you can deduct the loss then. Another reason the difference between passive and active income is important is that passive income is generally subject to that Net Investment Income Tax (or NIIT) we talked about earlier, whereas active income is not. That's an extra 3.8% that goes to the tax man (or lady! or non-binary person!).