Ordinary Income Tax
The tax rate applied to most types of income, including wages, business profits, and short-term capital gains, which is typically higher than long-term capital gains tax rates for real estate investors.
Key Takeaways
- Ordinary income tax applies to most regular earnings, including wages, business profits, and certain real estate gains.
- For real estate, rental income and profits from properties held for less than one year (short-term flips) are typically taxed as ordinary income.
- Ordinary income tax rates are progressive, meaning higher income levels are taxed at higher percentages.
- Understanding ordinary income tax is crucial for calculating the true profitability of real estate investments, especially for short-term strategies.
- Tax deductions and depreciation can help reduce your taxable ordinary income from real estate activities.
What is Ordinary Income Tax?
Ordinary income tax refers to the tax rates applied to most types of income you earn. This includes your salary or wages from a job, profits from a business, interest earned on savings accounts, and certain types of gains from investments. Unlike capital gains tax, which often has lower rates for assets held for a long time, ordinary income tax rates can be higher and are based on a progressive system, meaning the more you earn, the higher your tax rate on portions of that income.
How Ordinary Income Tax Applies to Real Estate
For real estate investors, understanding ordinary income tax is vital because several common income streams from properties are subject to these rates. This primarily includes net rental income from properties and profits from properties bought and sold within a short period, typically less than one year. These are considered active or short-term gains and are not eligible for the lower long-term capital gains tax rates.
Common Sources of Ordinary Income in Real Estate
- Net Rental Income: The money you earn from rent, after deducting eligible expenses like mortgage interest, property taxes, insurance, and maintenance.
- Short-Term Capital Gains: Profits from selling a property you owned for one year or less. This is common in fix-and-flip strategies.
- Wholesaling Fees: Income earned from assigning a contract to another buyer without actually taking ownership of the property.
Real-World Example
Imagine you own a rental property that generates $2,000 in gross rental income per month. Your total monthly expenses (mortgage interest, property taxes, insurance, repairs, property management fees) average $1,200. Your net rental income is $800 per month ($2,000 - $1,200). Over a year, this is $9,600 ($800 x 12). This $9,600 will be added to your other income (like wages) and taxed at your ordinary income tax rate. If you are in the 22% tax bracket, you would owe approximately $2,112 ($9,600 x 0.22) in federal ordinary income tax on this rental profit, before considering any other deductions like depreciation.
Understanding Tax Brackets
The U.S. tax system uses tax brackets, which are income ranges taxed at specific rates. For example, in 2024, a single filer's first $11,600 of taxable income is taxed at 10%, the next portion up to $47,150 is taxed at 12%, and so on. Your ordinary income tax is calculated by applying these different rates to portions of your total taxable income. This means not all your income is taxed at your highest marginal tax rate, but rather each portion falls into a specific bracket.
Frequently Asked Questions
What is the main difference between ordinary income tax and capital gains tax?
The main difference lies in the tax rates and how long an asset is held. Ordinary income tax applies to most regular earnings and short-term investment gains (assets held one year or less), typically at higher progressive rates. Capital gains tax applies to profits from selling assets, with lower rates for long-term gains (assets held over one year) and generally higher rates for short-term gains, which are taxed at ordinary income rates.
Does rental income always count as ordinary income?
Yes, generally, the net profit from rental income is considered ordinary income. This is the income left after you subtract all eligible operating expenses from your gross rental revenue. However, certain deductions like depreciation can significantly reduce your taxable rental income, lowering your overall ordinary income tax liability.
How do tax brackets affect the amount of ordinary income tax I pay?
Tax brackets determine the rate at which different portions of your taxable income are taxed. The U.S. has a progressive tax system, meaning as your income increases, higher portions of your income are taxed at higher rates. For example, your first $11,600 might be taxed at 10%, while income above $47,150 might be taxed at 22%. Your total ordinary income tax is the sum of taxes from each bracket your income falls into.
Are profits from flipping properties always taxed as ordinary income?
Profits from flipping properties are taxed as ordinary income if you owned the property for one year or less. These are considered short-term capital gains and are subject to your regular income tax rates. If you hold the property for more than one year before selling, the profits would generally be taxed as long-term capital gains, which typically have lower tax rates.