Real Estate Taxation

Hereon this article, you will find information regarding taxation of income and gain from real estate investments, such as house, condo, apartment, commercial property and land at individual level.

A. U.S. Citizens and Resident Aliens

1. Rental Income (Reported on Form 1040, Schedule E)

You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property.

Expenses of renting property can be deducted from your gross rental income. You generally deduct your rental expenses including mortgage interest, repair costs, property tax paid, insurance, utilities, and etc, in the year you pay them. For more complete information, please visit the following link.

Publication 527, Residential Rental Property

If you own several, it is recommended to have separate bank accounts for each property to better control.

2. Gain from a Sale of Real Property (Information herein is solely on federal taxation. Capital gain is also subject to state tax)

Short-term (holding period less than a year) Gain from a sale of property is taxed at ordinary income tax rates up to 35%. Long-term (holding period over a year) gain from sale of a property is taxed at 5% and 15% depending on your personal income tax rate. However, depreciation expense taken up to the point of sale will be taxed at ordinary income tax rate and you may be applicable to pay tax based on AMT (Alternative Minimum Tax) rule. Sale of real property is reported using I.R.S. Form 1040, Schedule D and Form 4797.

3. Taxation of Like-Kind Exchanges (commonly known as Section1031 Exchange)

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, known as “boot”, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets. It also limits the location of property. Properties must be in the U.S.

To be a successful Section 1031 Exchange, there are compliance requirements as follows:

  • The 5-Day Rule. A “Qualified Exchange Accommodation Agreement” must be entered into between the taxpayer and the exchange accommodation titleholder (qualified intermediary in most cases) within five business days after title to property is taken by the exchange accommodation titleholder in anticipation of a Reverse Exchange.
  • The 45-Day Rule. The property to be “relinquished” (the relinquished property) must be identified within 45-days. More than one potential property to be sold can be identified in a manner similar to the rules of delayed exchanges (i.e., the three-property rule, the 200% rule, etc.)
  • The 180-Day Rule. The Reverse Exchange must be completed within 180-days of taking title by the exchange accommodation titleholder.

4. Installment Sales

The installment sale method allows the taxpayer to defer the inclusion of income until the payments is made in cash or a cash equivalent.    It is a way to defer income recognition.    A demerit is that not all sale proceeds can be used to invest at once.

B. Nonresident Aliens

Nonresident aliens are to use I.R.S Form 1040NR to file income tax returns.    A nonresident alien’s income that is subject to U.S. income tax must generally be divided into two categories:

  • Income you receive during the tax year that is effectively connected with your trade or business in the United States is, after allowable deductions, taxed at the graduated rates that apply to U.S. citizens and resident aliens.
  • Income that is not effectively connected is taxed at a flat 30 percent (or lower treaty rate) and no deductions are allowed against such income.

Nonresident aliens must pay a 30 percent flat tax on their U.S. rental property income (No deductions are allowed). This tax must be paid in the year in which they receive the income. There is, however, an exception that allows nonresident aliens to claim a deduction for rental expenses and be taxed at graduated rates on the net income. They can elect to treat rental income from real property as income effectively connected with a trade or business. Those electing to claim deductions on rental property must attach a statement to their tax return indicating this preference. Or they may use form W-8 ECI, “Foreign Person’s Claim of Income Effectively Connected with the Conduct of a Trade or Business in the United States.”

Gain from a sale of real property is always regarded as income effectively connected with the conduct of a trade or business in the United States and taxed at, after allowable deductions, the graduated rates that apply to U.S. citizens and resident aliens.