For the seasoned investor, real estate has long proven to be an attractive addition to any portfolio. Thanks to its long-term stability and its resilience even the most challenging market conditions or downturns, owning property is a lucrative endeavor.
One aspect that gives pause among property owners? The taxes involved in purchasing and earning income on their investments. Without fully understanding your tax burden, you could be in for a surprise when it comes time to take stock of your ROI.
Before making any purchase, it's essential to understand different tax policies and how they could impact your real estate investment – and why taking your business overseas could prove advantageous.
Five taxes to understand
Before committing to any real estate purchase, you'll want to examine the various tax concerns you may encounter. The following tax burdens, explained from the standpoint of purchasing domestic real estate for clarity, are the most common you'll encounter.
The first tax you'll want to understand is the transfer tax. Also referred to as deed transfer tax, this one-time fee is most often levied by a local or state entity whenever the transfer of real property occurs between two parties.
Any government entity, including those from the state, county, or city levels, may administer the tax. Most often, the tax is highly localized.
An "ad valorem" tax, the amount is based on the property's value at the time of the transfer. One of the most basic of taxes, the rates are higher on luxury properties.
Next are real estate income taxes. Should you own any investment properties, be it a short-term, seasonal, or long-term rental, the monies you earn are taxed as income. To calculate the taxable portion, deduct any eligible expenses from your total income earned.
Arguably the most well-known of real estate taxes is the property tax. Levied by local governments annually, property taxes provide cities and counties the funds necessary to address community infrastructure projects such as roads, schools, and emergency services, among many others.
Property taxes stay with the property and are levied against the current owner. Should you opt to purchase the property with cash or pay off a mortgage, you must continue paying the property tax.
Most commonly, funds stay in escrow, with a portion of your monthly mortgage payment funding the account. Your lender will pay your property tax bill from the escrow account at the end of the year.
Property taxes are by no means static. They can fluctuate from year to year, and they may increase quite a bit in trendy, sought-after markets.
Capital gains tax
Whether you're a homeowner or investor, you're required to pay capital gains tax should the monies earned from the sale of your home or investment property exceed their cost basis.
The net proceeds you earned are simply what you made from the sale less costs required to sell the property. To determine the cost basis, add the following:
- Priced you paid for the home
- Any additional costs that stemmed from your purchase of the property - appraisal, home inspection, application fees, transfer tax, etc.
- Cost of any major repairs or upgrades
Effectively, only the profit you made from selling the home is subject to the capital gains tax - your net earnings minus cost basis calculation. If the number is in the black, you'll more than likely be subject to the tax.
However, as one of the more complex property taxes (you can also owe capital gains on stocks, bonds, precious metals, and other property holdings like cars or boats), capital gains taxes offer the following exemption:
- For singles - $250,000 of capital gains on real estate
- For married, filing jointly - $500,000 of capital gains on real estate
For example: as a single, if you bought a home in 2015 for $500,000 then sold it in 2020 for $850,000, for a profit of $350,000, $100,000 of that would be subject to capital gains tax.
Additional exemptions from some of all of the capital gains tax burden include selling the home due to:
- Medical or health-related issues
- Job relocation
- You could no longer afford the home due to divorce, death, or natural disaster.
To take advantage of that exemption, any of the following must prove true:
- The property was your primary residence
- You lived in the home for two of the previous five years before selling
- You owned the home for two of the previous five years before selling
- You claimed the exemption within the previous two years of selling your current home
Section 1031 exchange
The final real estate tax to be aware of is the Section 1031 exchange (also called a like-kind exchange or Starker). Less a tax and more tax-related deferment, a 1031 is a swap or exchange of investment properties.
Instead of selling an investment home and keeping the proceeds (which could then be subject to capital gains tax), you use the proceeds to buy another investment property similar to the property you sold.
You're effectivity deferring payment of capital gains taxes as you sell your investments, assuming you meet one of the following conditions:
- The property you bought is like-kind to the one you sold
- The replacement, like-kind property is identified within 45 days from selling the first property and acquired within 180 days from the sale
- You must still pay tax on any non-like-kind property, cash, or benefits that were part of the exchange
Factors when buying internationally
Applying the above-listed tax burdens to international real estate purchases can alter your investment plans by a considerable margin. Depending on what part of the world in which you’re looking to invest, you could be facing either a substantial increase in your financial commitment or something far more favorable.
For example, U.S. transfer taxes are relatively small – it's a transaction fee more than a genuine tax. When buying in international territories, where transfer taxes can approach 10% of a property's purchase price, the transfer tax should be included as part of your overall purchase cost. $20,000 is a significant hit on a $200,000 property.
Income taxes come down to how you use the property. With few exceptions, what you earn on your international property is classified the same in the U.S. and abroad. However, though you can deduct expenses and depreciation here in the U.S., you can only deduct expenses overseas. The result is uneven tax bills where a credit on your overseas taxes may end up covering a U.S loss.
While property taxes are prevalent in the U.S., it's hit or miss internationally. In many countries that levy property taxes, they can be nominal fees payable online. In others, you'll have to hunt down the local tax office to retrieve and pay your bill.
As for capital gains, it too is hit or miss abroad. One thing that is certain is that U.S. residents are accountable for paying domestic capital gains for overseas property sales. If the country you sell the property in does have a capital gains tax, you owe nothing stateside if the tax is greater than domestic change or the difference if it proves to be less.
Before buying abroad, consult your tax specialist on what you will and won't be responsible for on your international investments.
Benefits of buying internationally
Of course, owning global real estate is about more than taxes. Several attractive benefits make international ownership equally as intriguing as buying domestically.
Depending on where you choose to invest, an overseas property may offer impressive returns. The key is to seek out deals in burgeoning markets, such as Cambodia and Georgia, and be wary of more established areas like the U.K. or Australia. Markets with room to grow can prove very lucrative.
More than just higher returns, owning abroad allows you the opportunity to establish a second residence (even a second passport), provides you a safe haven, and gives you protection and insurance should things ever go sideways at home. Events such as the pandemic can create plenty of uncertainty on otherwise stable U.S. shores. A second home across either ocean provides a space to retreat to until normalcy returns.
As rewarding as U.S. property ownership is, it's important to spread your wealth far and wide. From instability within the U.S. market (think 9/11 or the 2008 financial crisis) to those filing suspect lawsuits having to chase your assets around the globe, owning international real estate protects you, your wealth, and your assets from uncertainty at home.
Finally, real estate ownership far afield provides diversification. Not just in your investment portfolio but in your life. While your overseas assets are pumping lucrative returns into your pocket, you can be learning a new culture, establishing a new residence, and exploring the world. For long-term planning, buying property internationally lays the groundwork for an ex-pat retirement in a favorite landing spot or multiple territories of interest.
Ready to explore the best of San Francisco real estate, including prestigious penthouses and luxury condos? Contact the Gregg Lynn Team today to start your real estate journey. From Pacific Heights real estate to Noe Valley homes for sale, allow Gregg's years of experience and expertise to be your guide to the Bay Area luxury real estate market.