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Taxes and real estate investments: The basics

Tax considerations are important to the real estate investor.

Consult IRS Publication 527, "Residential Rental Property," available at www.irs.gov. It is also advisable to consult a tax professional to ensure that you are complying with the law, while maximizing allowable deductions and minimizing your overall tax.

Reporting your tax information

In most cases, you will use Schedule E with Form 1040 and include as gross income all amounts you receive as rent.

If you hold the property for rental, you recover the cost of the property through yearly tax deductions. You do this by depreciating the property.

In other words, you deduct some of the cost each year on your tax return. (Use Form 4562 to claim depreciation.) The depreciation deduction is in addition to your actual out of pocket maintenance and repair expenses.

The result is an increase in cash flow—the amount of money you get to keep after taxes. The depreciation period for residential real estate is 27.5 years.

This means your depreciation deduction will be 3.636 percent of your "basis" in the rental property (the building only, not the land) each year for 27.5 years. Typically, your basis is the amount you paid for the property, plus the value of any structural improvements (e.g., a new roof or furnace).

A sign is posted outside of a new housing development in Petaluma, California. (Photo: Justin Sullivan/Getty Images)
A sign is posted outside of a new housing development in Petaluma, California. (Photo: Justin Sullivan/Getty Images)

What about capital gains?

Upon selling a property, you will realize (hopefully) a capital gain—the difference between the amount you sell it for and your basis, which is usually what you paid for it (plus any structural improvements), minus the amount you have claimed as depreciation deductions since purchasing the property.

Capital gains are classified as long-term or short-term. If you hold the property more than one year, your capital gain or loss is long-term. If you hold it one year or less, the gain is short-term. Long-term capital gains are taxed at 0–20%, while short-term capital gains are taxed at your ordinary income tax rate.

Dive deeper: Real estate investing: The full breakdown

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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