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Comparing the tax implications of the different forms of real estate investments

Allan Tripon |

It is often said that there are only two things that are constant in this world: death and taxes. This mantra is especially true in the world of real estate investing as investors are faced with a plethora of taxes such as income taxes, capital gains taxes, business taxes, real property taxes, and documentary stamp taxes — among others. This article seeks to dissect and compare the tax implications of some of the different methods of real estate investments.

Buy and lease real estate investments

Income taxes
The National Internal Revenue Code (NIRC) of the Philippines treats any individual (lessor) who rents out real property to a lessee as a person ordinarily engaged in trade or business. The NIRC also requires that the real property being rented out to be classified as a depreciable ordinary asset — or an asset ordinarily used in business in layman’s terms. Thus, any taxable income earned by the real property shall be taxed using the graduated rates ranging from 0% to 35%.

The first step in getting the annual taxable income is to compute for the gross income. Gross income in this case shall come from two sources: (1) rental income and (2) gain on sale (if any).

Rental income is simply the total amount of cash received by the lessor from the lessee plus any accrued rent income (income earned but not yet received in cash). On the other hand, the gain on sale is computed as the selling price received less the depreciated cost (initial cost less any accumulated depreciation) of the real estate asset. Adding these two components will lead to the total gross income for the year.

Allowable deductions (business expenses in layman’s terms) are then deducted from the computed gross income in order to arrive at the taxable income.

The first and perhaps largest expense is the annual depreciation expense. This figure is computed simply by dividing the initial cost of the property by its expected useful life. Another allowable deduction is interest expense from any mortgages or loans related to the real property. Finally, any other necessary costs can also be expensed — such as repairs and maintenance, transportation, etc.

The computed taxable income shall then be subject to the graduated rates for individual taxpayers.

Business taxes and other tax implications
Aside from the income tax, certain lessors shall also be subject to various business taxes such as the 12% value added tax (VAT) or the 3% other percentage tax (OPT).

As a general rule, an individual who makes three million or less (in receipts) shall be subject to the 3% other percentage tax. On the other hand, individuals which breach the three million VAT threshold shall be subject to the 12% value added tax.

It is important to note, however, that residential property being leased out at a rate not exceeding ₱15,000 per month (₱180,000 per year) is exempt from both the value added tax and the other percentage tax.

Buy and trade real estate investments (short term)

Income taxes
The National Internal Revenue Code of the Philippines treats individuals who buy and sell real property more than six times within a taxable year as dealers ordinarily engaged in trade or business. Therefore — similar to the buy and lease investors, the related real estate asset is also classified as an ordinary assets. In this scenario — however, the ordinary asset is not depreciable since it will be classified as inventory. Any taxable income earned by the individual shall be subject to the graduated rates ranging from 0% to 35%.

The gross income of real estate dealers is equal to the gross profit of the sale. In simpler terms, gross income is equal to the selling price of the property less its initial cost.

Allowable deductions or business expenses are then deducted from the gross income in order to arrive at the taxable income. Business expenses for real estate dealers often include selling expenses, administrative expenses, and entertainment and recreation expenses.

Business taxes and other tax implications
Aside from the income tax, certain lessors shall also be subject to various business taxes such as the 12% value added tax (VAT) or the 3% other percentage tax (OPT).

As a general rule, an individual who makes three million or less (in receipts) shall be subject to the 3% other percentage tax. On the other hand, individuals which breach the three million VAT threshold shall be subject to the 12% value added tax.

It is important to note, however, that residential property sold for less than ₱2.5 million is exempt from both the other percentage tax and value added tax.

Buy and hold real estate investments (long-term)

Income taxes
The National Internal Revenue Code of the Philippines essentially treats buy and hold investors of real estate as passive investors (not ordinarily engaged in trade or business). Therefore, the real property is classified as a capital asset (not an ordinary asset) and the graduated income tax rates are not applicable. Rather, the transactions by these individuals are covered by the capital gains tax on real property.

The capital gains tax on real property is a special tax regime which taxes the selling price received on the sale at a flat rate of 6%. For comparison, dealers are only taxed for the gain on sale.

Another key feature of the capital gains tax is the exemption provided for the sale of an individual’s principal residence — provided that the following requisites are met.

1. The real property sold is the seller’s principal residence.

2. The proceeds of the sale will be used to acquire a new principal residence within 18 months from the sale.

3. The exemption can only be availed of only once every ten years.

4. All the administrative requirements of the Bureau of Internal Revenue are complied with.

A transaction which meet the said criteria is exempt from the capital gains tax.

Business taxes and other implications
Long term buy and sell operations are treated by the tax laws as casual sales (and not an ordinary business operation). Therefore, these transactions are not subject to any business taxes.

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