With the recent attention given to wealth in our country, how much income you have and what taxes you pay have become important concepts for most people. More than ever before, people are aware of their personal income tax liabilities and how they can reduce or avoid paying them by investing in different types of businesses and/or living expenses.
Income is defined as money that comes into your life from sources such as salary, dividends, interest, etc. In general, we agree that having more income is better but how it’s taxed depends on who collects it and why!
This article will go over some basic definitions of income, average taxable incomes, and how real estate investment strategies may be able to lower yours. Also, I will discuss whether or not owning a house is a good idea if you want to keep lots of cash liquid.
I will also talk about ways to effectively minimize your income tax bills through deductions and cost segregation. By being proactive with your investments, you will know exactly what you are doing with your money. This will help remove the mystery factor when it comes to avoiding taxation.
Real estate has been an effective way to build long term wealth so this topic will definitely not be boring. To read my full recommendations, check out my link at the end of this article. Let’s dive in!
Definitions
Before diving into higher level topics, let’s review some fundamental terms related to income and taxes.
Long-term capital gains
A long term capital gain is defined as the difference between what you paid for your home and how much it sold for at auction, or sale, minus your cost. This is typically the more difficult to achieve, but most wealthy people use this strategy to make their income tax burden lower.
The way that many people reduce their taxes through investment strategies is by considering all of the expenses in their business deductions. These include things such as legal fees, office supplies, advertising, etc. People also deduct mortgage interest from their income, so investing in a house can be a good way to save money!
However, one area that is sometimes overlooked when investing in real estate is the effect that owning a home has on your personal net worth. When someone sells their house, they are usually given the amount of profit and the value of the property in exchange.
This means that their total net wealth decreases because they have less cash, and often times no longer have a second residence. Obviously, being taxed on both income and net wealth can add up quickly!
By investing in a low-income housing program or renting, your financial situation will remain relatively stable, which should limit the impact that buying a new home would have on your taxable income.
Short-term capital gains
This is what most people refer to when they talk about income tax in real estate. It’s typically referred to as “penny stock taxes,” because this type of income is very small (often less than $100) and so it only accounts for a tiny fraction of overall income taxation.
Short-term capital gain means your house was worth more than you paid for it, but you sold it within one year. So instead of reporting the profit as ordinary income (equivalent to earning extra money), you report that loss as a short term capital gain.
This can be confusing, however, because there are different rules depending on whether you’re in the 10% or 15% tax bracket.
Real estate investment trusts (REITs)
As mentioned before, real estate investing is not necessarily free from income tax. In fact, it can be quite expensive depending on your personal situation. One of the most important things to know about investing in real estate is how tax laws apply to you as an investor.
Income taxes are paid at both the federal level and the state level. The federal government also offers several different tax breaks that benefit investors. This article will go into more detail about these benefits!
Real estate investments may or may not be treated as a form of business for tax purposes. If they are considered business-level expenses, then they can reduce your taxable income. More importantly, if your losses outweigh your gains, then you can deduct those losses from other sources of income.
This article will talk about some potential pitfalls when investing in real estate, as well as some strategies to avoid them.
Passive income
What is passive income? That’s a great question! Passive income means your money does the work for you, it comes in steady streams, and most people don’t have to deal with it directly. As such, most people (including me at times) view it as pure profit, which isn’t wrong, but it misses the whole purpose of having wealth — to give you more freedom.
With that said, there are two main types of passive income:
1. Qualified dividends from stocks or revenue shares from businesses
2. Renting out part of your house or apartment
This article will talk about how both of these forms of income are taxed differently depending on whether they are considered qualified dividend income or rental income. After reading this, you’ll know what kinds of returns you can expect dependent on if you earn through real estate investing!
Disclaimer: The information contained within this site should not be regarded as tax advice by any given individual. Please consult your own personal advisors before making any significant changes to your business or personal financial situation.
How Are Dividends Taxed?
Dividend taxes were first introduced back in 1924 when Congress passed a law requiring companies to tell their shareholders each year how much was being paid out as a dividend.
Active income
What is active income? That’s another way to describe what most people refer to as “income.” It includes things like salaries, dividends, interest, royalties, capital gains (when you sell an asset for more than you paid for it), and certain types of business profits.
The very word income implies that we earn it by doing something. For example, if I pay someone to work for me, then that person has earned their paycheck. If I invest in a stock or bond market, I am earning money because I’m paying to use the facilities that company provides to gather information about its products and make predictions about how they will do in the future.
In fact, Warren Buffett says that one of his favorite ways to get rich is investing in stocks, so he clearly thinks that offering financial services to others is a method of gathering wealth.
But while investment activities can result in income, they are not always treated that way when real estate investors report their earnings. This article will go into greater detail on why this happens and some strategies to avoid this tax loophole.
Self-employment taxes
There is an additional tax that self-employed individuals pay on their income that is not called a “tax” but instead is referred to as a net earnings tax or NET. This was enacted in 1934 and applies only to business profits (not capital gains).
This tax is calculated by taking half of your gross sales, then multiplying it by two. The reason for this is because most states require you to report your total revenue in order to determine whether you are eligible for various state benefits.
For example, if you run a restaurant, you must report both your food sales and the cost of producing those foods. States calculate how much money you made off of each item and add them up to see what kind of income you had. If the sum of these products is greater than zero, then they consider you to be in business and therefore you have to tell them about your business.
Most people refer to this as the Net Sales Requirement. A part of this requirement is paying an additional half of your gross sales in self-employment taxes.
However, there is some wiggle room when it comes to defining what constitutes being in business. Some experts say that running a restaurant is not considered to be in business unless you spent more time in the kitchen than at the table setting up orders. Others disagree and feel that anything related to making or selling food makes you in business.
Social security tax
Another major source of income for most individuals is what’s known as social security or payroll taxes. These are fees that employers contribute to your personal health insurance account, and they’re paid through your paycheck.
This includes both the employee contribution rate towards their own individual coverage, and the employer contribution towards an employment benefits package (such as medical, dental, and life insurance) that may be available to you via an affiliated company like Aetna or Blue Cross.
The more generous these benefits are, the higher the cost-of-living paychecks get with each check that gets cashed out. Therefore, the longer the person works, the higher total income earned in this field.
But there’s a problem: As of 2018, employees have to pay a 6% additional amount onto their social security payments per every thousand dollars made over $100,000 per year.
Medicare tax
Another important factor when it comes to real estate income is how much tax you owe depending on what kind of business you are running. There is an additional tax that most people are not aware of-the so called “Medicare” or general health insurance tax. This tax applies to all individuals, even if you aren’t buying or selling a lot of property!
This tax was first implemented back in 2004, and now there is a very specific time frame during which this tax must be paid. If you earn more than $50,000 per year (or $100,000 for married couples), then you have until April 30th after the end of the year to pay this tax.
If you happen to close out a rental property or sell a house at the end of the year, any money made above the $50,000 ($100,000) limit will be taxed twice – once as ordinary income and again as a medical expense.
