Factors that affect an individual’s tax outcome as a real estate investor
Real Estate Investor tax mistakes – Different people can co-own a parcel of real estate and each experience a different tax treatment when they file their tax returns. Some of the factors that affect an individual’s tax outcome would be whether the investor is treated as passive, active or a real estate professional; whether the investor has other household income that may limit deductible losses; or whether he or she is renting to a family member.
When investing in real estate, it is important to discuss your situation with a tax advisor who is knowledgeable in real estate matters. The real estate sections of the Tax Code are some of the most complex. Before you invest in a new property, be sure to find out how it will affect your overall tax picture. Your tax situation may be quite different than your neighbor’s. Know if being a faith based real estate investor has any tax issues.
In addition, the tax treatment of real estate can vary dramatically based on whether the property is income property (rented out); investment property (held long term); inventory property (bought or built to sell); the intentions and actions of the investor; whether the property will be used as a residence, vacation home, or a myriad of other factors.
Below are five costly mistakes many real estate investors make when they fail to consider the whole tax picture.
Mistake #1: Not Understanding What Makes Real Estate Expenses Deductible
If the property you purchase is to be used as your primary residence (or your home), then your deductions are limited to mortgage interest (subject to limitations), property taxes, points, and mortgage insurance protection (temporary law).
If you were to buy another house without renting it out, you may be able to treat it as a second home. The deductions for a second home are limited to mortgage interest (subject to limitations) and property taxes.
Real Estate Investor tax mistakes/If you bought a third house or have land that is not rented out, then your deductible expenses are limited to property taxes, and the mortgage interest is classified as “investment interest.” Investment interest can only be deducted against investment income, such as dividends and interest income. Expenses, such as maintenance, fencing, and other land expenses are not deductible except as investment expenses, or they can be added to the cost basis of the property. If the expenses are added to the cost basis, then they would be deducted when the property is sold, thereby reducing the gain or increasing the loss on the sale.
The amount of your real estate expenses that is deductible in any given year is determined by whether you are a “passive” investor or whether you “actively participate” in the rental activity, or whether you “materially participate” in the rental activity.
The IRS deems everyone that holds real estate, other than your personal residence(s), a “passive” investor, unless you can qualify as an “active participant” or “material participant.” If you do not qualify as an active participant, then your losses are considered passive and can only offset other passive types of income, such as interest, dividends, or income that flows through to you from limited partnership K-1s, or other such investments. Interest cost of dept has pros and cons.
Passive losses that are greater than your passive income cannot be deducted immediately, but are to be carried forward to future years. This carry forward is called a Passive Activity Loss Carry Forward and is tracked on your 1040 tax return.
An investor who actively participates in rental activity is allowed to deduct certain expenses up to $25,000 more than the income taken in as rents. For example, if you collected $10,000 in rents, but had $37,000 in deductible expenses and depreciation, then you would take a $25,000 rental income loss and carry over the $2,000 balance as a Passive Activity Loss Carryover (subject to income limitations). Costly Mistake #2 is all about these limitations.
Mistake #2: Buying a Rental for Tax Benefits without Considering Limitations
If you bought a rental property because you wanted to deduct rental losses against your other income in order to reduce your income taxes, then you may be disappointed. The tax law contains passive-loss rules that limit deductions (see Costly Mistake #1).
Real Estate Investor tax mistakes/If you, the real estate investor, want to be able to deduct rental losses, you need to qualify as an “active participation” owner. To be an active participation owner you must participate in the day-to-day management decisions of the property or properties, or be actively arranging for others to provide services (such as repairs). Management decisions include such things as approving new tenants, deciding on rental terms, and approving capital or repair expenditures. Real estate consultants and property managers can help with these issues.
You are treated as actively participating even if you hire a property manager or others to provide services, such as repairs. Your lack of participation in operations does not prohibit your qualifying as an active participant as long as you are involved in significant decision making.
As an investor with rental income properties, you can qualify for the full $25,000 rental property loss deduction IF you actively participate in the rental AND your modified adjusted gross income is $100,000 or less. The law phases out your deductible loss at a rate of one dollar for every two dollars of modified adjusted gross income in excess of $100,000, with full phase-out reached at $150,000. The phase-out amount is not deductible on the current tax return and should be carried forward for a deductible benefit sometime in the future.
Beware if you file married filing separately (MFS). There is no passive loss allowed if you file MFS and you lived with your spouse during the year. If you did not live with your spouse during the year and file MFS, then the $25,000 loss is reduced to $12,500 and the income ceiling is reduced to $50,000.
So, you can see why so many people that buy a rental property are disappointed at tax time. You should always get the opinion of a tax advisor before making a large investment.
Mistake #3: Failing to Maximize Allowable Rental Losses
If you find yourself slightly over the income level that disqualifies you from benefiting from the full $25,000 loss, a little planning and restructuring can modify your income to put it in the range for you to qualify for the full $25,000 loss on your rental properties. Or, if you are not able to take the full loss benefit, then perhaps you can modify your income enough to take a partial loss benefit.
Real Estate Investor tax mistakes/You can benefit greatly if you are able to take the actions needed to reduce your modified adjusted income below $150,000 for a partial benefit, or preferably, reducing it to the $100,000 level to qualify for the full $25,000 income loss benefit. This loss can be used to offset other ordinary income on your tax returns, thereby reducing your income taxes.
One strategy that could be enacted to reduce your modified income is to increase your tax deductible contributions to an employer’s retirement plan, such as a 401(k) contribution, thereby reducing taxable wages.
What if you are self-employed? You can reduce your profits from self-employment by increasing Section 179 deductions. This can be accomplished by purchasing a new vehicle for your business or buying qualifying equipment. Dealing with problem tenants can also cost money that can be a tax issue.
Strategic timing is the key to fixing Costly Mistake #3. You must know what your modified adjusted gross income is BEFORE the end of the year, so that action can be taken before it is too late!
Mistake #4: Not Understanding the Difference between Repairs and Improvements
One of the most important decisions you’ll make as you own your properties involves distinguishing between “repairs” and “improvements.” Repairs are deductible immediately as you make them. Improvements are depreciable over time. It usually makes sense to characterize fix-ups as repairs so you can deduct them faster.
Real estate investor tax mistakes 2/In general, the repair deduction is about 3000 percent more valuable to your current bottom line than an improvement is. A repair is fully deducted now, whereas a capital improvement is taken over a period of 27.5 or 39 years. An improvement costing $27,500 would only allow a current year deduction of $1,000, if using the 27.5 year method.
Defining the terms “repair” and “improvement” seems straightforward enough. Repairs keep your property in good operating condition. They don’t add value and they don’t prolong the property’s use. Examples include painting, plastering, repairing broken windows, and fixing gutters, floors and leaks.
Improvements adapt your property to new uses, add value or prolong its use. Examples include room additions, upgraded appliances, new landscaping, and replacing components like furnaces, roofs and windows.
Capitalization rules do not allow the expense to be treated as a repair and may require you to capitalize even the interest portion of the expense for the time the property was out of service.
If you must improve the property without it being in service, then do it quickly. Keep it out of service for less than 90 days, so as not to automatically fall under these rules.
Tax Tip: For tax purposes you never want to “improve” your rental property and try your best not to remove a tenant (taking the property out of service) while you make “repairs”. By removing a tenant, you not only suffer a loss of cash flow while the property is out of service, but you can trigger something even more serious, the uniform capitalization rules.
Mistake # 5: Not Making the Most of Depreciation
Depreciation is the process of writing off a capital asset, such as a rental property, over a period of time intended to approximate its useful life. The IRS says that residential properties last 27.5 years, whereas nonresidential properties last 39 years.
Real estate investor tax mistakes 2/Good tax planning tells you to accelerate your deductions and defer your income. You can greatly enhance the acceleration of your depreciation deductions if some components of your property could be depreciated using either a 5 year or 15 year depreciation method rather than the 27.5 or 39 year depreciation methods.
Separate out Land Improvements. We all know that land is not depreciable, but what about land improvements? Driveways and sidewalks crack, landscaping needs replacing, and pipes from the house to the street deteriorate over time. You can depreciate land improvements over 15 years. Land improvements include the following:
- Sidewalks, roads, and waterways
- Drainage facilities and sewers
- Docks and bridges
- Fences, landscaping, and shrubbery
Trees and shrubs planted near a new building are generally depreciable. The IRS grants depreciation for the trees and shrubs close to the building because when you tear down the building, you also tear down the trees and shrubs.
However, you may not depreciate the trees and shrubs located away from the building. Those costs are considered part of the cost of land when constructing a new building. They are not depreciable and must be capitalized (added to the cost basis of the land). They give no tax benefit until the property is sold.
Separate out Personal Property. You can break out certain “personal property” and depreciate it separately, such as appliances and equipment. By separating personal property from the building, you are allowed to accelerate the depreciation over as little as 5 years—which gives you far more deduction in the early years that you own your property.
By separating some of the components of a building into depreciable classes, the deduction for some assets can be accelerated. Instead of depreciating an entire building over 39 years, the land improvements can be separated out and depreciated over 15 years (250% faster); the equipment can be separated out and depreciated over 5 years (nearly 800% faster). A little planning can greatly enhance your current tax benefits.
By Randy Roth, EA, CSA, MSFS
The foregoing is intended to provide general information, not specific tax or legal advice. For specific advice you should contact your tax advisor, or you can contact us.
About the Author
Randy Roth is a tax, estate & business consultant. His practice concentrates in the areas of tax preparation and planning for individuals, businesses, estates, trusts and non-profit organizations. He is knowledgeable in real estate matters, including the taxation of real estate, estate issues involving real estate, as well as the business of real estate. He can be reached at his firm, Incompass Tax, Estate & Business Solutions at (916) 974-9393. The office location is: 4600 Roseville Road, Suite 150, Sacramento, CA 95660.
