Ask a Real Estate Investment Advisor: Real Estate Tax Advice for Current Investors

by | Nov 14, 2022 | Taxes, Investing

Recently, our own Derek Williams, CFP® sat down to answer the four biggest real estate investing questions we hear from clients and the public about purchasing investment properties. That article for beginner real estate investors addressed the top factors and considerations to keep in mind before you purchase your first investment property. But what about current real estate investors who either inherited their initial investment property or came to Cook Wealth with real estate investments already in their portfolio?

This companion article, for current real estate investors already active in the market, will cover three additional investment property questions we often hear about maximizing your tax savings, navigating property sales, and creating an estate plan that benefits both you and your children.

These are the 3 most common real estate investing questions we hear from current investors

I have an investment property that’s appreciated considerably. What should I do with it?

What we often see is people who either inherit a home from their parents and choose to keep it as a rental property, or couples where each member already had a home, and when they move in together, they keep the second property for rental income. And all’s fun and profitable— until home prices really increase.

Property values have skyrocketed over the past two years as demand wildly outpaced supply and mortgage interest rates hit historic lows. That’s great news for real estate investors who renovate and resell their investment properties quickly. But for these individuals who either inherited real estate investments or held onto that second home and now have rental properties that appreciated a lot, the news isn’t all good.

Higher property values translate to higher property tax. And at some point, those property taxes can wipe out your ROI and make what used to be great rent income more of a liability than an asset. Not just that, but the more property values increase, the more you’ll have to pay in capital gains taxes when you do decide to sell those real estate investments.

A quick refresher on capital gains tax: When you sell a rental property, the difference between the price you bought it for and the price you sell it for (a.k.a. your net profit) is considered income for tax purposes. There are some tax deductions you can take to reduce that amount, but whatever is leftover you’re required to pay capital gains taxes on. And that tax can be a lot.

Consider this example— If you bought your rental property a few years ago for $220,000 and put in about $20,000-worth of improvements and maintenance, then you sell your rental property in today’s hot real estate market for $350,000, you’ve now got a capital gains tax bill due on your $110,000 profit. Depending on your income level and how long you’ve owned the rental property, you could be required to pay anywhere from 15% to 37% of that profit in capital gains tax! Many investors don’t realize how serious a tax event can be triggered when they change their rental activities— until the giant tax bill comes next spring.

So if you’re sitting on real estate investments that have grown considerably over the past few years, it’s a good idea to make an exit plan with your tax professional and wealth advisor before you make any big investment decisions. Here at Cook Wealth, we help our real estate investors create customized tax strategies that maximize their tax benefits, minimize their business expenses, and build wealth in the process.

Should I keep my real estate investments if I’m nearing retirement?

This is a great question, and one every individual nearing retirement age should be asking. A lot of our retired clients choose to hold onto their rental properties. Not only does the rental income help their cash flow, many individuals enjoy the property manager responsibilities that come with maintaining rental property.

For real estate investors who can purchase with cash, the rental income potential is significant. If you have five rental houses and you purchase them with savings, and each brings in about $2,000 per month, that’s $10,000 in somewhat passive income you can count on. There will always be operating expenses and property repairs to plan for, plus additional fees if you choose to hire a property manager, but the income potential remains strong.

If I’m working with a retirement-aged client who funded their real estate investment using cash and is bringing in the rental rate needed to cover the property taxes and maintenance costs, I ask one more question: Do you want to continue managing your rental properties during your Golden Years? Including the maintenance costs, the middle-of-the-night calls, and the turnover?

If the answer is yes, then there’s no reason you can’t be a successful real estate investor well into your retirement years. However, most often I find that the risk factors and extra effort required to manage real estate deals, renters, and maintenance outweigh the benefits— especially compared to other forms of passive income that are equally or more profitable.

How can I include my real estate investments in my estate plan in a way that benefits my children?

As I shared above, the longer you hold onto each real estate investment, the more complicated the paperwork and taxes become. There’s a few reasons for this added complication:

  • The longer you’ve been the rental property owner, the harder it becomes for your tax preparer to calculate your cost basis (the baseline amount the IRS believes your property is worth).
  • That complicated cost basis is what will be used to determine the inheritance tax your children will owe, plus the capital gains they’ll pay when they eventually sell the real estate investment.

If your children are prepared to manage the tax paperwork, and take on responsibility for the property tax and property management, we can work with you to create an estate plan that transitions the property ownership smoothly when the time comes.

However, if your children are running their own businesses, have their own careers, live out of state, or aren’t in the place to take over your real estate investing business, it may be smarter to work with a real estate professional who can help you sell the property and maximize your earnings. By transferring your wealth into other assets that do offer passive income, you can save yourself time and effort while simplifying your estate plan.

That being said, if you’re in a good place with your rental real estate income and you have a streamlined setup, we’ll work with you to maintain those investments and continue offering the most sound financial advice possible. At the end of the day, when you work with Cook Wealth, you’ve got a partner that’s on your side— and we’re here to help you reach your financial goals in the way that best fits your lifestyle and unique situation.

At Cook Wealth, we help real estate investors manage their income, minimize their taxes, and enjoy the journey

That’s why every client has access to a joint tax and wealth advising team with experience navigating the complexities of real estate investing. To learn more about our comprehensive real estate investor and financial advising services, jump on a quick, 15-minute call with our team here.