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Do I Need to Pay Capital Gains Tax on Investment Property?

If you're looking to invest in real estate, the market may support your ambitions. After years of free-falling home and land prices, the American housing market appears to be bottoming. As ambitious investors continue to mop up the nation's foreclosure overhang, the number of distressed properties appears to be shrinking at a slow but steady clip. A reduced foreclosure glut will eventually provide strong price support and may contribute to a resurgence in the value of residential property. Although the commercial property market still looks weak, it may soon follow the harder-hit residential market into recovery.

Investing in land or physical homes may be a great way to take advantage of this accelerating secular trend. Then again, real estate investments aren't risk-free. Before you dive into the treacherous waters of real estate investing, you'll want to understand the tax implications of your endeavor. Unlike your primary and second residences, your surplus investment properties may be subject to certain federal and state tax levies.

Chief among these additional levies will be capital gains taxes. When you sell your primary residence, you're not required to pay capital gains taxes on the profit that you realize on the property. This long-standing rule is designed to encourage home ownership and facilitate the selling process. The gains that you realize on the sale of your "second" or vacation home are typically exempt from capital gains taxes as well.

Under the current tax laws, any additional homes that you own are treated as investments. Even if you live in your third or fourth home for several months out of the year, it will still be subject to the laws that govern investments in stocks, bonds, commodities and other traditional vehicles. As such, you'll need to pay capital gains taxes on its sale.

If you sell your property for a loss, you may be able to deduct a certain amount of the loss from your top-line income figure. This deduction is typically capped at $3,000 per year. If your loss is larger than this amount, you may be able to "carry over" the deduction into future tax years. For instance, you might be able to claim a $9,000 capital loss on three consecutive tax returns.

Finally, it's important to note that you can deduct the value of any improvements that you make to the home from your profit figure. Depending upon the cost of these improvements, this could substantially reduce the amount of capital gains tax that you must pay on the sale of your investment property.

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