Find Your Real Estate Investing Tax Breaks

Real estate investing tax breaks are one of the big reasons many investors buy property. As an investor, you can write off all sorts of things that will end up reducing your taxable income, and therefore, reducing the amount that you owe.

Just to give you a feel, here are some of the things you can deduct that you're probably already spending money on in your real estate investing activities:

Travel to go see your property (Maybe it's even in the same city as your in-laws or your favorite beach vacation spot)
Interest on your mortgage for the property
Insurance on the property
Property Management, Accounting, Legal Fees, Accounting, and other professional advice
Training and education associated with your property
Repairs and Maintenance at the property

But remember, you can't charge for your own time working at the property, you can only account for things that you pay someone else to do. So, the next time you're wondering whether to pay the neighbor's kid to mow the lawn at your rental property or do it yourself, remember, you'd be paying him with pre-tax dollars.

Don't buy a property JUST to save money on taxes...

Tax savings can really add up! They can turn a property that puts money into your pocket every month into a tax write-off. But remember, it's not all fun and games. You still have the responsibility of finding a good deal, managing your property, and selling it when the time is right. Don't buy a property JUST for the tax benefits alone (a lot of people who did that got wiped out - bankrupted! - in the 1980's when the tax law changed and their tax write-off's went away.) Always make sure your property fundamentals are sound!

Knowing When To Sell To Maximize Tax Breaks

Knowing When To Sell To Maximize Tax Breaks Speaking of selling property, bear in mind that one of the purposes of the tax law is creating incentives for you to do certain things. The government is rewarding you (with tax breaks) for taking desired actions.

In the case of real estate investing, the government wants to reward you for holding property long term (over 1 year) as affordable rental housing in many cases - rather than having you get rich with short term fix-and-flip strategies.

If you hold the property for less than a year, the government treats your income as short-term capital gains tax, which is taxed at your ordinary income tax rate (that's HIGHEST of your tax brackets, usually).

To get the lowest tax rates, hold the property for at least a year and your profit on the sale will be considered long-term capital gains and the tax treatment will be much better. Currently, long term capital gains tax rates are just 15%, but President Obama has suggested he will raise the tax rates to 20-25%... so stay tuned!)

If you don't want to pay any taxes at all when you go to sell your property, consider participating in a 1031 Exchange, or Starker Exchange (same thing, different names). This is a transaction in which an intermediary helps you sell one property and then buy another similar investment property. You can roll all your profits from the sale of the first building into the purchase of the second building. If you do - you won't pay any tax on the new building! Do your own research, but it's worth getting more information on 1031's if you're selling a property with a lot of equity and want to make sure you'll minimize your tax bill!

Real Estate Professional Status

Long term capital gains tax treatment isn't the only real estate investing tax break in jeopardy... The Real Estate Professional status is also getting harder to qualify for. Real Estate Professional is an IRS designation which says you spend at least 750 hours a year working in real estate investing, and that real estate is your primary business. If you qualify for this designation, you have the ability to deduct ALL your losses from real estate, even if they are in excess of $25,000/year. If you don't qualify, your real estate deductions may be limited, especially if you are a passive investor not actively involved in real estate investing, or you have an especially high income.

Another bug-a-boo in the land of real estate investing tax benefits is the AMT or Alternative Minimum Tax. This is a tax that hits high income earners if they have too many tax deductions, even if those deductions are legitimate. Congress keeps patching this, but it's hitting - and hurting the middle class. If you earn more than about $130,000/year this may affect your family, so consult with a tax advisor to see if you'll be able to take advantage of the real estate tax breaks you're expecting.

More Real Estate Investing Information

Please, as you read through this article, bear in mind that I am not an accountant or tax attorney. I am another investor like you and I am just sharing from my own personal experience. Tax law is complicated and changing, so I encourage you to consult with your own team of professionals on any topics that you need more information on or strategies you plan on implementing.

Alternative Minimum Tax Impact From Investing Activities

Income that is earned from investments is a significant factor in the amount of Alternative Minimum Tax an individual pays. Certain types of investment income (dividends, capital gains, certain interest, e.g.) as well as the amount of this income in relation to the taxpayer's other income, all factor into the AMT formula. A taxpayer usually has much more control over investment income than he does his salary, for example, making this source of income much more important from an Alternative Minimum Tax planning point of view. In general, an investment portfolio can be changed any time a taxpayer finds it advantageous to do so.

Discussed below are a few key items associated with investing activities, and the AMT planning opportunities that may exist.

Dividends and capital gains

Most dividends on common stocks are "qualifying," and, thus, are eligible for a lower tax rate than "ordinary income," which consists of things such as salaries and wages, interest income, rental income, and the like. Similarly, a capital gain that qualifies as a "long-term" capital gain also is eligible for this lower tax rate. Even though the tax rate on dividends and capital gains is the same for both the Regular Tax and the AMT, the effect on a taxpayer's exemption amount can mean that these items of investment income are the reason a taxpayer is paying the AMT.

Planning strategy - determine the real tax rate being paid on dividends and capital gains. For maximum returns, investors should always consider after-tax yield when evaluating investment alternatives.

Tax-exempt bond interest

In general, municipal bond interest is exempt from Federal tax. However, certain muni bonds are designated "private activity" bonds, depending on how the proceeds of the bond issuance are used. Interest from private activity bonds continues to be exempt for the Regular Tax, but it is fully taxable for the AMT, with the result that the after-tax yield is significantly less than what the taxpayer originally thought he was earning. Note that, in order to boost yields, certain muni bond funds may allocate a portion of their portfolios to private activity bonds.

Planning strategy - Again, a taxpayer always should be considering after-tax yield in evaluating investments. An AMT payer generally should not be holding private activity bonds. If the investment is in mutual fund form, there are plenty of muni bond funds available that do not invest in private activity bonds.

Partnerships and other "pass-through" investments

In many cases partnerships themselves will have AMT items, but since a partnership "passes through" these items, it is the individual partner who ends up paying the AMT. For example, a real estate partnership may use a depreciation method that is allowable for the Regular Tax but is not allowable for the AMT. This difference in depreciation methods is an AMT item that will be reported to the partner on the Form K-1 he receives from the partnership, which, in turn, must be reported on the partner's own AMT schedule, the Form 6251.

Note that this same pass-through treatment results in the case of S corporations, LLCs, and certain estates and trusts.

Planning strategy - Before investing in a partnership, an individual should inquire about AMT items that the partnership may generate. Once invested, it generally is too late to do anything about them.

Conclusion

While the old maxim that taxes should not determine an investment strategy is true, nevertheless an investor who is stuck in the AMT may be earning a significantly lower after-tax yield on his investments than he realizes. Remember that it is only after-tax income that an investor actually gets to keep; ignoring taxes, especially the AMT, is unwise.

Investing for Children - Which Options Are Best? (Part 2)

Having given due consideration to the strategies in Part 1, let's now consider other tax effective investments to help children with the costs of higher education.

Trust Arrangements

In cases where the donor is confident that the child will have a mature disposition at age 18, a bare trust based investment will offer maximum tax efficiency.

Where more control is required over the investment so that there is, in effect, a "wait and see" approach before the child benefits at age 18, a discretionary trust may be more appropriate.

We will now look at these in more detail. Clearly, in either case, the underlying investment should be made to achieve maximum tax efficiency within the constraints of the required investment parameters.

It is not generally legally possible (although certain life policy exceptions do exist) to make outright gifts of assets to minor children and obtain a valid legal discharge. Indeed, it is not often advisable from a practical standpoint. For this reason trusts can be used effectively.

Two options exist:

Bare Trust

Here the donor could consider an investment into a collective investment (unit trust or OEIC) held subject to a bare trust for the absolute benefit of the child.

The advantages of this structure would be:

Income

Where the grandparent is the donor, income will be taxed as the grandchild's. It is likely that the grandchild will be a non-taxpayer. This means that where dividend income arises, recovery of the tax credit on those dividends will not be possible and so, if this is of importance, an investment in corporate bond funds could be considered.

These generate interest distributions which are paid under deduction of income tax at 20% and this can be recovered by or on behalf of a non-taxpayer.

Alternatively, an investment in an offshore corporate bond fund could be considered. Here interest is paid
gross and so this will avoid the need for a reclaim of tax.

In cases where the parent is the donor of a bare trust for the benefit of his/her minor child who is unmarried and not in a civil partnership, then if the gross income on investments within the trust exceeds 100 gross in a tax year, it would be taxed on the parent. Therefore, if the parent is a higher rate taxpayer, it may be appropriate to invest in low yielding investments and concentrate an achieving capital growth.

Capital growth

Capital gains will be taxed on the child so this could be a useful way, through careful investment management, of using the child's annual CGT exemption of 10,100 (tax year 2010/11).

Moreover, the annual exemption is not restricted according to the number of trusts created by the same settlor. Any gains that exceed the annual exemption in a tax year will probably only be taxed at 18%.

Where investment funds are held in a bare trust and being invested to assist with the future payment of university costs, the collective investment could be gradually encashed over three or four years. The child could draw down on the investment from age 18 and, provided capital gains fall within the annual CGT exemption, in effect enjoy a tax-free stream of capital payments.

Another investment that could be held in a bare trust is a single premium bond. H M Revenue and Customs now takes the view that where chargeable event gains arise on single premium bonds heldsubject to a bare trust, they should be taxed on the beneficiary.

The exception to that is in cases where the beneficiary is the settlor's minor unmarried child not in a civil partnership where the "100 rule" applies (ie. if gross income exceeds 100 in a tax year, it is taxed in full on the parental settlor). However, this rule doesn't apply with a grandparent settlor or a parental settlor once the child attains age 18.

Therefore, if full policy/segment encashments are made from a bond, chargeable event gains may well count as the child's income and so, provided the child is not a higher rate taxpayer, in effect provide a series of tax-free payments.

To facilitate some tax-free encashments to fund the costs of pre- university education the 5% (tax-deferred) annual allowances could be used in the knowledge that on eventual encashment after the child had attained age 18, a tax charge is unlikely to arise. Of course, tax (while important) should not be the only determinant of underlying investment strategy.

Investors should always aim to strike an appropriate balance between investment suitability and tax efficiency - ideally achieving both.

Gifts to bare trusts are PETs and so no immediate IHT would arise. Indeed, they will be totally free of IHT if the donor survives for 7 years.

Discretionary / Flexible Trust

A discretionary trust would give control to the trustees to determine who should benefit from the gift and when. This means that if the child does not have a financial need at age 18 or is not responsible enough to receive cash at that time, the release of benefits could be held back until a later date.

Aside from the 1,000 standard rate band, trustees of discretionary trusts are charged to income tax as if they are additional rate taxpayers. Since 6 April 2010, the tax rates on income above this band arising to discretionary trustees are 50% (42.5% on dividends) regardless of the trust's level of income.

This means that in cases where a grandparent is the settlor, it may be appropriate for the trustees to distribute income to a grandchild beneficiary who is a lower or non-taxpayer in order to recover the additional rate tax paid by the trustees.

Indeed, in these circumstances an interest in possession trust that gives the grandchild a vested right to income but with the trustees having the power to appoint capital may be attractive as this will avoid the beneficiaries having to recover income tax that the trustees have already paid.

In cases where the settlor is the parent of a minor unmarried child beneficiary, it should be noted that
the "100 rule" can apply. This means that if more than 100 of gross income in a tax year is paid out of the trust to the minor child beneficiary of the settlor, it will be taxed on that parental settlor.

Another planning point to consider, where appropriate, might be to trigger the "settlor-interested trust
rules" by including the settlor's spouse in the class of beneficiaries. This would result in the income being assessed on the settlor which would lower the tax rate provided the settlor is not an "additional rate" taxpayer.

Two types of investment may be appropriate for the trust.

Collectives

If income was not to be distributed it would generally, from a tax standpoint at least, be best for the trustees to invest for capital growth, for example in collectives. This will enable them to use their annual Capital Gains Tax exemption, which is normally 5,050, with excess gains only taxed at 28%. However this investment strategy may introduce an increased level of risk into the portfolio.

Should an adult grandchild have a need for cash at or after age 18 in circumstances which would mean the trustees would have a likely CGT liability, the trustees could make an absolute appointment of benefits to the grandchild and claim CGT hold- over relief. This would mean that the gain would effectively be transferred to the beneficiary, who would have his full annual CGT exemption (10,100) to offset against
any capital gains that arise on subsequent encashment.

Investment Bonds

Alternatively, (and especially if the settlor-interested trust or gains oriented collective strategies were not possible or appropriate) in order to avoid the high rate of tax that trustees pay on trust income, the trustees could invest in single premium bonds.

In such circumstances, any chargeable event gains (which will include reinvested income within the bond) will automatically be taxed on the settlor if he/she is alive and UK resident in the tax year in question.

Their top rate of tax may well be lower than that of the trustees. Otherwise, chargeable event gains will be taxed on UK resident trustees at 50%, with a 20% tax credit available in respect of chargeable event gains arising under a UK bond.

A UK single premium bond could thus be a particularly tax attractive investment where there is a desire to invest for growth from reinvested income rather than capital gain.

In cases where the trustees wish to encash the bond to realise cash to make a payment to an adult beneficiary to fund university costs or assist with a mortgage or wedding costs, thought could be given to making an appropriate appointment of capital, and then the trustees assigning the bond to that adult beneficiary.

That would not in itself trigger a chargeable event but future chargeable event gains on encashment of the bond will be taxed on the beneficiary at his/her tax rate which will hopefully be lower than the rate paid by the settlor/ trustees.

Gifts to discretionary trusts are chargeable lifetime transfers but an immediate IHT charge would only arise if the settlor exceeded his nil rate band (on a seven year cumulative basis).

Whilst ten-year periodic charges can arise, these are only likely to be an issue if a substantial amount was being placed in trust which is fairly unlikely in these cases.

The Financial Tips Bottom Line

Children will need help in later life to meet a number of financial commitments - be it university costs, assistance in buying a house or funding the costs of a wedding. All of these costs can be expected to increase in the future.

Unless large sums of capital are available, the only realistic way of financing these costs is for a parent or grandparent to set up an advance programme of saving.

The demise of the Child Trust Fund means that Government help will not be available in the future.

All parents and grandparents / guardians need to be aware of tax-efficient investment products and, where appropriate, trusts to maximise the returns available for the child. Where trusts are used, these can enhance tax efficiency and the trust selected can be tailored to meet the parent / grandparent's and child's circumstances.

Commodity Investing and Tax Benefits

With tax season just passed, you may still be hurting from the results. If you requested an extension and haven't filed yet, this topic might be very helpful to you. Aside from the profit potential that you can realize from trading commodities, there are handsome tax benefits as well. The current tax laws separate investment gains and losses into two expansive groups: short-term capital gains and long-term capital gains. This feature is nice because when you are commodity investing, you are allowed to split your profits between the two categories.

To understand the tax benefits of commodity trading, there are a couple of things to learn. Grab the statements from your commodity account and a calculator, and start a spreadsheet; this is quick and fairly easy to grasp. Here are the things you need to do:

1. Understand what short-term capital gains are. Profits from any commodity trade that is held for less than one year are considered short-term capital gains. Short-term capital gains are taxed at the investor's normal tax rate; if you are in the 25% bracket, your short-term gains will be taxed at 25%.

2. Understand what long-term capital gains are. Commodity trades that are held for more than one calendar year are long-term capital gains. Long-term capital gains are taxed at a flat rate of 15% unless you are in the ten percent or fifteen percent brackets and then long-term capital gains are taxed at 5%. For those people who are holding long-term futures contracts, this is obviously a very attractive situation.

3. Add up your profits and losses. This is where you can use your calculator (or your computer if you have some spreadsheet skills). For each transaction you made while commodities trading, enter the amount of profit you made as a positive number and the amount of loss you had as a negative number. For example, imagine that you made three commodity trades; you earned $500 on the first, lost $300 on the second and made $1,000 on the third. To calculate your profits, add the numbers together. $500 - $300 + $1,000 = $1,200; $1,200 would be your profit for the year.

4. Determine your long-term capital gains. For this calculation, take the total number and multiply it by sixty percent. For our example, $1,200 x 0.60 = $720; this is your long-term capital gains on your commodity investing. Now you need to multiply this number by the 15 percent tax rate; $720 x 0.15 = $108. This will be the long-term capital gains tax responsibility on your commodity long-term investing.

5. Determine your short-term capital gains. For this calculation, take the total number and multiply it by forty percent. For our example, $1,200 x 0.40 = $480; this is your short-term capital gains for your commodity investment strategies. Now you need to multiply this number by the 25 percent tax rate (For this example we'll assume this is your rate but we hope it is higher!); $480 x 0.25 = $120. This becomes your short-term capital gains tax responsibility on your commodity investments.

6. Add the two together. Once you add the short and long-term tax numbers together, you have calculated your tax liability for your commodity trading. $108 + $120 = $228.

7. Review your savings. In order to see your savings, multiply your total profit for the year by your tax rate and then subtract your actual tax responsibility from this number. (Remember that we assumed you were in the 25% bracket.) $1,200 x 0.25 = $300; this would have been your liability. $300 - $228 = $72. While on the surface this doesn't seem like a lot but it is actually a 24% reduction in your tax burden for the money you made! 24% can make anyone's investment philosophy look pretty smart!

Conclusion

Because of the method for computing capital gains, commodity investing can be very beneficial from a tax standpoint. Since futures contracts are taxed at a split rate, 60 percent of your earnings from commodity investments are taxed at the long-term capital gains rate and only 40 percent is taxed at the short-term capital gains rate. This is called the 60/40 tax treatment, and it will save you money in taxes. As always you should consult your tax advisor but you will likely be very pleased with your returns!

A Guide to Tax Efficient Investing

Trying to invest tax efficiently can be frustrating when the playing field keeps changing. With taper relief, it used to be really efficient to have a large AIM portfolio - now it isn't. You used to get capital gains tax rollover through VCTs - now you don't. However, there are still plenty of ways to invest in a tax-efficient way.

The most obvious for any stock market investor is of course the ISA. You can put £7,200 this year, unless you're over 50, in which case you can invest £10,200 - next year, that goes up to £10,200 for everyone. Over time, you can build a fairly significant ISA portfolio.

An ISA will give you several advantages. No CGT. No income tax on dividends (though you still pay 20% through the tax credit which can't be reclaimed). And no need to fill in anything about it on your tax form. While the income tax break isn't significant unless you're paying higher rate tax, the CGT tax break can be very useful. You can take profits on your positions without having to worry about whether you're going to incur CGT. A £100,000 portfolio might only generate £4,000 in dividends a year - but you're much more likely to incur over the £9,200 capital gains tax threshold of profits.

Now you can also gain efficiencies by investing in a SIPP (or indeed any other pension scheme). The tax benefit here is up front - you can claim your contributions as an allowance against your income tax liability. I won't go into it in detail now, but subject to the lifetime and annual limits this can be an efficient way to invest.

VCTs are another useful break. These are investment trusts which invest in smaller companies and comply with various stringent regulations; you can invest up to £200,000 a year (rather a lot more than with an ISA!) and you can get 30% tax relief on that. To get the up-front tax relief you have to subscribe to a new VCT issue. But there are also advantages to buying second-hand shares, since all VCT dividends and capital gains are tax free. So if you have a large enough portfolio to be paying CGT most years and can't shelter all of it in an ISA, if you ask me, VCTs make good sense as an investment.

What's wrong with VCTs? Plenty. They invest in smaller companies so can be high risk. And they are often very illiquid, so really not suitable if you're going to need the money. I don't like to call it 'investment', but for more active investors wanting to make some of their capital gains tax free, spread betting has its attractions. The Inland Revenue says it's not investing, it's gambling - so there is no tax payable on your winnings. If, of course, you have any.

The tax man will inevitably take some of what you earn - and rightly so! But its worth doing your research and using your tax allowances and tax-free savings schemes to the full. That way, you can minimise what you're giving to the government - and do so, I hasten to add, completely legitimately!

Capital Gains Tax Rates in the UK

It is mandatory to pay capital gains tax if you dispose of any asset by transferring or giving it way. You are also subject to paying the CGT if you receive compensation, for example, you may receive compensation for a damaged good from an insurance company.

You do not have to pay any capital gains tax on the sale of your car, and first home, under most conditions, ISAs or PEPs, UK government gilts (bonds), income from betting, lotteries or pool winnings, or in other words, any money that is already subject to income tax.

Calculating the CGT:

When you sell an asset: Let us assume you bought some shares for £1000 and you sold them for £2000. You would need to pay CGT on the gain which in this case is £1000.

When you give an asset: It is important to point out that you need to pay CGT on the value of the asset and not what you get from it. To illustrate this, let us consider that you bought a flat for your son at £70,000 four years ago and its value has now appreciated to £100,000. Suppose you let him have it at less than the market value, £75,000. Your gain would be £100,000 minus £70,000 which is £30,000.

When you dispose of an asset: If you dispose of an asset which you received as a gift, your gain will be based on the market value when you received it. For example, you are gifted a garage whose value at the time when the gift was made was £5000. Now you sell it for £8000. Your gain in this case will be £3,000.

Investing In The UK Through An Offshore Company To Avoid UK Tax

Capital Gains Tax Holding UK investment via an offshore company would look at first glance to be a good way of avoiding UK capital gains tax. As the company is non UK resident,and provided the assets aren't used for the purpose of a UK trade they will be exempt from UK capital gains tax (or more correctly corporation tax on the capital gain).

Note though that this tax exemption only applies if the company retains the cash until the shareholder is non UK resident or if the cash is retained overseas. Any extraction of the proceeds would be taxed to the extent that they were remitted to the UK. So whether a simple dividend is paid or if the company is liquidated and a capital distribution is paid the cash would need to be retained offshore. If you wanted to enjoy the proceeds in the UK you'd need to think about methods of remitting the proceeds with minimal UK tax implications.

A big problem with using an offshore company is in ensuring it's controlled from overseas. If it was controlled from the UK it would be UK resident and as such taxed in full on any capital gains realised. If the company owns UK assets it makes it more difficult to avoid the company being classed as UK resident.

Inheritance taxUsing an offshore company is a big advantage for inheritance tax purposes, as it converts a UK asset into an overseas asset. As non UK domiciliaries are not subject to Inheritance tax on overseas assets they can then avoid tax on the UK property owned by the offshore company. One point to note here is that it's important that the company shares pass on registration. They will then be classed as located where the share register is - which if this is outside the UK will ensure that the shares are excluded property.

Income taxA directly owned foreign holding company can at the most only achieve only a a partial avoidance of UK tax. Income tax, unlike capital gains tax is still taxed on UK source income. Therefore even if an offshore company is used, UK tax will still be charged on UK income.

However there are benefits to be obtained from using an offshore company. For example there can be a saving of higher rate tax as non resident companies are subject to the lower or basic rate of tax in respect of UK source income. Note though that you can obtain some income (eg UK bank interest) free of UK tax. This is because tax on this income is restricted to tax deducted at source if the recipient is a non resident.

SummaryAn offshore company investing in the UK can look to achieve the following tax benefits:

Avoidance of capital gains tax
Avoidance of inheritance tax
Partial avoidance of income tax
Anti avoidance rulesAside from the company residence position - which is always an issue where you have an offshore company with UK shareholders there are also the anti avoidance provisions to consider.

Note that there is also the related issue that if an individual exercises control over the company and makes it UK resident there is a risk that he may be a shadow director and any benefits provided to him (or his family) from the company would be charged to income tax.

The main anti avoidance provision that applies to income is S739. Although there is an exemption for non UK domiciliaries this does not apply to the company's UK income.

Therefore if the offshore company had UK investment income this provision would deem the income of the company to be that of the person establishing/transferring to the company originally.

Another useful point to note is that S739 applies to any foreign registered company.

When can the anti avoidance rules be avoidedOne is where the UK individual buys a company that already has the UK investments in it. Provided he doesn't inject any further assets to the company he shouldn't be within the scope of the legislation (as he's not made a transfer of assets resulting in income accruing to the company).

Secondly there is the motive defence which applies where the transfer was not for the purposes of avoiding UK tax, and was for a wholly commercial purpose. One case where this is more easily satisfied is where a non domiciliary established the company before coming to the UK.

When can the offshore non resident company be used as a tax shelter for UK investments?It can be used to avoid UK Inheritance tax It can be used to avoid UK tax on any capital gain It can be used as a partial shelter for UK income if S739 is avoided in one of the above ways.

However any extraction of the income or proceeds from the company to the UK would be subject to UK tax. Therefore ideally income/proceeds should be retained overseas.

Investing in Real Estate, Flipping Houses, and Income Taxes

Understand the tax consequences of flipping houses, rehabbing houses, and how to defer taxes with the 1031 Exchange before you get into real estate investing. Problems arise when real estate investors don't follow federal and state tax laws. This is why you need professional advice. Although I am not a tax advisor, here are some common mistakes beginning real estate investors make by not understanding tax liabilities:

Flipping Houses

The reason flipping houses is a mistake for some beginners is that they don't know the income tax consequences. One problem with flipping houses, or selling too many properties too quickly, the IRS could say that your real estate business is your trade, subject to ordinary income and self-employment taxes.

Self-employment tax, a social security and Medicare tax primarily for individuals who work for themselves, is similar to the social security and Medicare taxes withheld from the paycheck of most employees. The self-employment tax rate costs you 15.3% of your profits. (However, this may provide retirement benefits.)

Rehabbing Houses

Another common mistake that beginning investors make is selling a property after holding it for almost a year. Some rehabbers work part time on a fixer and take six months to get the house ready. Add on two months to sell with a 60 day closing, and they're up to ten months. To take advantage of the low 15% capital-gains tax rate, you must keep the investment property for at least a year before selling. If you sell before a year, your tax rate, the usual capital gains rate of 35%, could eat up a significant amount of your profits.

If you're rehabbing houses, be patient. You could save thousands in taxes by holding your property just a few more weeks.

1031 Exchange

However, the Internal Revenue Code provides real estate investors away to defer capital gains taxes indefinitely. Section 1031 of the Internal Revenue Code provides a tax-free exchange. Also known as a "like-kind" exchange, this code allows you to sell a business or investment property and defer capital-gains taxes by immediately reinvesting the gains into a similar piece of property. The key, replacing a business or investment with similar property, means that no gain gets paid to the investor. Any profit taken out of escrow gets taxed. This means that beginning investors might take out a portion of the profit after they carefully explore their tax liabilities. In other words, talk to an accountant and find out what your tax would be according to your current usual income. Many business owners take advantage of this because they have many business deductions.

The big mistake beginning real estate investors make doing a 1031 tax-free exchange, taking possession of the profits, voids the tax deferment. You must declare the sale of your property to be a part of a 1031 exchange before you sell the property. Then you have the money placed in a trust account held by an intermediary until you purchase the new investment property. You have 45 days to identify a replacement property and 180 days to close on the new investment. You can't purchase a primary residence or a vacation home with funds from an investment property and defer taxes in a 1031 exchange.

The best advice for beginning real estate investors:
Talk to an accountant.

Would you be better off making extra money, even if you must pay taxes?

© 2005 Jeanette J. Fisher.