How are real estate investments taxed? What potential investors should know

• Real estate investing can generate interest, dividends, rental income, business income, and capital gains, depending on how the investment is structured.
• If you invest in a rental property, you can reduce your taxable income by subtracting any expenses for managing and maintaining the property to rent.
• A 1031 exchange allows real estate investors to swap one rental property for another, deferring capital gains on the transaction.

There are many reasons you might want to invest in real estate. Owning property can offer income through appreciation - when the home's value increases over time - and can be a source of passive income if you rent it out. And it's a good way to diversify your investment portfolio.

Investing in real estate also brings tax benefits, like the ability to write-off certain expenses for income properties. But like all things related to the IRS, real estate taxes can be pretty complex. Below is a look at the tax implications of real estate investing, along with the major tax benefits to keep top of mind.

What types of taxes is real estate subject to?

When dealing in real estate, the kinds of taxes you'll be subjected to will depend on whether you're a property owner or simply an investor. For example, if you own a home or condo and rent it out, you'll pay property taxes to your state or local government, income taxes on the rental income you earn, and capital gains taxes if you later sell the property at a gain.

That's very different from investing in real estate through crowdfunding, a real estate investment trust (REIT) or a real estate limited partnership (RELP). Without the hassle of actually owning a property, the taxes you're subjected to are individual income taxes.

Here is an overview of the different types of taxes you might pay when you own or invest in real estate.

Property taxes

State and local governments impose property or real estate taxes annually to help pay for schools, police and fire departments, roads, and other state and local services. Property taxes are usually based on the property's assessed value, including the land, buildings, and other improvements. Property tax rates vary greatly depending on what city and state you live in.

Net investment income tax (NIIT)

Some types of real estate investing result in investment income, such as interest and dividends. If you're a high earner and make a lot of money off of your investment income, you will have to pay NIIT, which the IRS applies at a 3.8% rate to certain net investment income. The IRS has outlined on its website who is subject to paying this type of tax, which is based on filing status and modified adjusted gross income (MAGI).

Real estate income tax

When you rent out real estate, the rental income is considered passive income and is taxed as regular income. Just make sure you meet the IRS' definition of what's considered passive income, which you can do by taking the material participation test to determine whether you actively participated in a business or if it's truly passive income.

Business income tax

In some cases, renting out real estate counts as a trade or business. This happens only if you provide more than basic services. For example, you could buy a property and turn it into a bed and breakfast, providing linens and meals for guests.

Capital gains

Selling real estate can also generate capital gains if you sell the property for more than its cost basis. Your cost basis is the price you paid for the property, plus any acquisition expenses and improvements, minus depreciation.

Your tax rate will depend on whether it qualifies as a short- or long-term capital gain.

Short-term capital gains are from selling assets owned for less than a year, which are taxed at ordinary income tax rates. Long-term capital gains are for assets owned for a year or more and are taxed at a lower rate than ordinary income, with rates ranging from 0% to 20%, depending on your total taxable income.

Individual income taxes

If you're simply an investor and don't actually own property, any gains earn interest income taxed at the same rate as your other ordinary income.

How different real estate investments are taxed

The taxes you pay on real estate investments depend on the type of investment and the type of income it generates. Here are the four different types of real estate investments and how each are taxed.

1. Rental property

When you purchase a property and rent it out, you'll owe taxes on your net rental income. This means you're allowed to reduce your taxable rental income by subtracting expenses for getting the property ready to rent and then managing and maintaining it.

Rental income is taxed at the same rate as other ordinary income, such as wages from a job. Federal income tax rates range from 10% to 37%, depending on your total taxable income. If you're in the 24% federal income tax bracket, you'll pay 24% on your taxable rental income.

However, rental losses are subject to the passive activity loss rules, which can be quite complicated. These rules limit your ability to offset other income with passive losses.

There are two exceptions that might allow you to used passive losses to offset other income:

• Passive loss allowance. If your MAGI is less than $100,000, you can deduct up to $25,000 in passive losses against other income. This $25,000 deduction phases out by $1 for every $2 that your MAGI exceeds $100,000. Once your MAGI goes over $150,000, you have no remaining passive loss allowance.
• Qualifying real estate professional. If you qualify as a real estate professional, your rental activities aren't considered passive income. To qualify, you have to spend more than half of your working time on real estate trades or businesses and spend 750 hours or more on the real property business and rentals.

2. Real estate crowdfunding

In crowdfunded real estate investing, how you're classified as an investor - non-accredited or accredited - will affect how you're taxed.

Non-accredited investors participate in "debt deals," acting only as a lender for other property investors and don't actually own the property. That type of investment generates interest income taxed at the same rate as your other ordinary income and is reported to the IRS using Form 1099-INT. And if you earn more than $1,500 in interest income, you'll also have to prepare Schedule B.

Accredited investors participate in "equity deals." An equity deal gives you shares representing property ownership, and you receive rental income and capital gains. Capital gains may be short-term, in which they're taxed at ordinary income rates, or long-term and qualify for preferential tax rates.

If you participate in crowdfunding real estate investing, you should receive a K-1 tax form sometime before March 15. This form shows the income or losses from your investment during the prior year and you will use it to complete your individual income tax return.

3. Real estate limited partnerships

With RELPs, you can earn rental income and capital gains as you would if you'd invested in real estate on your own. There are two partners in this type of business relationship: a "general partner" who takes on the liability and a "limited partner" who is a hands-off investor.

A RELP isn't required to pay taxes, although it's required to file a Form 1065 to the IRS to report all income to the IRS. The partners then receive a Schedule K-1, showing their share of the investment's net income. The Schedule K-1 is used to prepare each partners' individual tax return.

4. Real estate investment trusts

Investing in a REIT typically results in two types of investment returns: dividends and return of capital.

Dividends from a REIT are usually non-qualified dividends, which are taxed the same as ordinary income. A return of capital is not taxable income, but it reduces your basis in the investment, resulting in higher capital gains when you eventually sell your REIT shares.

At the end of the year, you should receive a 1099-DIV showing your dividend income from the REIT.

Tax advantages of real estate investing

Real estate investing offers several tax advantages.

• Lower rates for long-term capital gains. Real estate tends to appreciate over time, so it's common for real estate investors to sell a property for more than they paid for it. As long as you hold on to the property for more than a year, you can benefit from the favorable tax rates for long-term capital gains.
• You can claim depreciation. When you use real estate for business purposes or rent it out, you can depreciate - or write off - the property's cost over time, which will reduce your tax bill. The IRS has set depreciation periods for real estate: For residential properties, the depreciation period is 27.5 years and for commercial real estate, it's 39 years. For example, if you purchase a single-family rental property for $100,000, you can deduct $3,363 of depreciation per year. You can also depreciate certain improvements, such as replacing the roof or installing a new HVAC system.
• 1031 exchanges. A 1031 exchange lets real estate investors swap out an investment property for a like-kind property and deferring capital gains. While a 1031 exchange can save you thousands of dollars in taxes, they are complicated transactions and come with a lot of tax rules. For that reason, you should always work with a professional to ensure it's done correctly.
• Rental income is not earned income. Unlike wages from a job or self-employment income, rental income isn't subject to Social Security and Medicare taxes (FICA). While this isn't an enormous benefit compared to other types of investment income, it can result in significant savings compared to normal earned income. For example, say you get a part-time job in which you earn $20,000 per year. You would owe $1,530 in FICA taxes on your wages. On the other hand, a rental property that brought in $20,000 of income per year would result in no FICA or self-employment taxes.

The financial takeaway

There are many tax advantages to investing in real estate, but paying taxes on these investment returns can be complicated. In order to be prepared for any tax implications you might expect from real estate investing, it's best to work with a tax professional who can explain which tax benefits might apply to you.