REI: Tax Issues - The last couple of years has probably been a lively one for those of you with substantial investments in real estate. The low interest rates continue to drive the real estate market, so the end of this strong market may be a ways off. Here are a few issues to think about when you are jumping into the real estate market:Cash Flow:
Many real estate investors purchase property to generate rental income. The goal for such investors is simple: positive cash flow. One of the easiest ways to increase your positive cash flow is to lower your monthly payment by refinancing at a lower interest rate. What some people do not realize is that there are also "interest-only" loans that can shave another 20% off monthly payments. Rather than pay both principle and interest (traditional), why not simply pay interest? At the end of 30 years, you still have saved what in the meantime would have been reinvested and generated substantially more than that amount. If your decision to invest in real estate is for positive cash flow and appreciation, paying off the principle does not make much sense anyway.
Tax Issues:
The typical real estate investor has one or two primary goals. For some, the goal is to purchase real estate and hold the property for the appreciation. For others they are looking to buy and sell and catch a quick profit (flipping). For the former group, the property is usually rented while the investor allows for the appreciation. The property is eventually sold, giving rise to a couple of tax considerations. They are as follows:
Capital Gains
When the property is sold, the gains are considered capital gains so long as the owner is considered an investor. This is great because if the property is held longer than a year, the long-term capital gains rates apply.
Installment Sales
Simply put, an installment sale is when property is sold at a gain and the payments are made in at least two tax years (i.e. the year of the sale and thereafter). Under an installment sale, the gain is reported (and taxed) as each payment is received. The payments consist of interests, gain, and basis.
The benefit of the installment sale for an investor is the deferral of the taxable gains into future years. Further, the gain portion of the payment is allocated over the life of the contract, so down payments tend to be largely tax-free when they are received, with the tax allocated over future years.
Opting Out
For some investors, the benefit of deferring taxes is not as important as limiting the total amount of tax paid. For such investors, they may wish to "opt out" of the installment method and have the entire profit taxed in the year of the sale. The reason someone would do this is as follows: the gain is calculated on the sale by using the fair market value of the note, not the face value, so the gain will be less and the tax will be less. For example, if an investor bought a property for $50,000 and sold it a few years later for $75,000 with a $10,000 down payment and a note for $65,000, the note would be discounted to its fair market value, probably $58,000, to calculate gain. This means the investor would pay taxes on the net gain of $17,000 ($75,000-$58,000) in the year of the sale as opposed to paying out the $25,000 worth of gain ($75,000-$50,000) over the life of the note or contract under the installment method.
