You can reap huge profits as your real estate investment appreciates, even after an adjustment for inflation.However, not all investments are equal in the eyes of the IRS, how your investments are taxed can make a big difference in your wealth.This takes us to the next big advantage of real estate investing, TAXES.
Fundamentally, there are two types of taxes, income tax and capital gains tax.The federal government taxes an individual’s earned and unearned income, which is it main source of revenue.Capital gain is the amount an asset's selling price has increased above its initial purchase price.You realize a capital gain when you sell an investment at a profit.Currently the IRS taxes realized capital gains.
Since the return on a bank savings account is simple interest, it is unearned income and taxed at the maximum rate for your income bracket, up to 35%.
You must pay a capital gains tax on the sale of stock, bought outright or on margin.Currently the capital gains tax for an asset held for more than a year is no more than 15%, which is much better than the income tax rate structure.If you hold stock less than a year, you must pay a short-term capital gain tax at the maximum rate for your income bracket, up to 35%.
When you sell stock within a 401k account, no income or capital gains tax is paid, independent of the holding time.However, you cannot realize your profits until you withdraw funds from your 401k, which is a taxable event.Depending on your age, withdrawal from a 401k can have significant financial penalties but at the very least will be treated by the IRS as income and taxed at the maximum rate for your income bracket, up to 35%
Real estate investments can fall under several different taxes, depending on whether you are flipping or holding, your level of activity and how long you hold the investment
Flipping homes is a process of investing in real estate with the goal to add value to the investment and then quickly re-sell it, realizing financial gain.Flipping is usually done over a short period, typically much less than one year.If you occasionally flip a home, the IRS will treat the realized profit as short-term capital gains, which are taxed at the maximum rate for your income bracket, up to 35%.
If you are an active flipper, the IRS will designate you as a Dealer, and treat all your financial gains as earned income and not only apply an income tax but also a self-employment tax, currently at 15.3%.In addition, a real estate dealer is ineligible for 1031 tax deferred exchanges.
The sale of a real estate investment held for at least a year can trigger a capital gains tax event unless the tax is deferred by transferring capital gains to a new property, per a “1031 exchange” (IRS Tax Code 26 U.S.C. § 1031).While there are rules that must be followed to perform a 1031 exchange, the capital gains can be transferred to a “like kind” real estate property without triggering a taxable event.By deferring the payment in taxable capital gains, you have more of your money to leverage your next real estate investment.An active real estate flipper cannot use this powerful tax advantage.
You also can realize the appreciation of a real estate investment without triggering a tax event by simply refinancing.Again, banks will not refinance unless the property is held for a significant period so that real estate flippers cannot use this powerful and unique advantage to help make the rich.The ability to realize financial gain and not initiate a taxable event gives real estate another gigantic advantage that can make you rich!
Not surprising, our federal tax code can be very confusing and we have not addressed how the various states tax investments!The complexity of the tax codes is why it is strongly recommended that you seek professional tax advice before you venture into either stock or real estate investing.We learned a long time ago that we are not tax professionals and have always had our returns prepared by tax accountants that are also real estate investors.
