Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal or financial advice related to individual situations. Consult with your own attorney and/or other advisor regarding your specific situation.
I won’t lie. I am frustrated. This whole paying taxes thing, I am over it. Yeah, I know it helps to pay for our overall infrastructure as a country—but still!
In case you are wondering why I am writing about this now, I just filed my taxes on October 15. Yes, I extend my tax return like clockwork on April 15 every year and buy myself another six months. I do nothing for five, and then after using some expletives, I finally begin the arduous task of going through thousands of pages of bank statements and recording everything.
Do you think I need a better system or no? Hmm…
It has become a vicious cycle. One that’s quite dreadful. It is obvious that I need a better system, and I am vetting bookkeepers and virtual assistants now to help with this task.
I want to talk about something else though—something even more frustrating.
I owe about $8,000! Dang.
For context, I owed about $4,000 last year and $10,000 the year before. That is a lot to some and pennies to others, but I still am on a mission to get that number lower—especially because I hear from all these gurus and even large companies that they pay no tax at all.
Here is the good news. I am finally getting a better grasp on how this whole tax thing works and what I can do to improve my position.
How to Pay Less in Taxes as a Real Estate Investor
Here is how I see it: The biggest roadblock to paying less taxes, for me, is the fact that I have a day job and cannot designate myself as a “real estate professional” for tax purposes. Well… I could but, my research shows that is nearly an automatic audit. Meaning, if you hold a full-time day job, the IRS has a very hard time believing you are a “real estate professional” instead of whatever you actually do as your normal full-time job.
Here are some ways the IRS says you can qualify as a real estate professional (from 2018’s IRS Publication 925).
You qualified as a real estate professional for the year if you met both of the following requirements.
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Furthermore, should you be audited, you will need a comprehensive log of all of your activities throughout the tax year to substantiate your “real estate professional” claim. You will need to demonstrate that you actually did perform qualified tasks and how long they took according to the guidelines above.
Take a look at that first bullet point above, again. It references that all of this work performed must be in “real property trades or businesses.” Here is what the IRS says is a “real property trade or business”:
Real property trades or businesses. A real property trade or business is a trade or business that does any of the following with real property.
- Develops or redevelops it.
- Constructs or reconstructs it.
- Acquires it.
- Converts it.
- Rents or leases it.
- Operates or manages it.
- Brokers it.
Ok, well, what the heck does all this really mean?
If you do not meet these qualifications, then you will have limitations. The limitation most commonly brought about is the $25,000 in real estate losses limitation.
What does this exactly mean?
The rental income that you make does not come in the form of a nice little paycheck like you get from your employer, right? There is no paystub with various federal and state deductions. Your tenant(s) pay you, and you pay the mortgage (if there is one), taxes, insurance, and the upkeep of the property.
Ordinary & Necessary Expenses
The tax code says that you are allowed to deduct for “ordinary and necessary” expenses though. This means you can deduct the cost of the paint used to turn around a vacant room, the cost of a pest exterminator to rid your units of cockroaches, and of course, interest on your mortgage, among many other items. All of these various items get added up and are used to offset your gross rental income.
Here is the problem. At the end of the day, you may still be left with income above and beyond what you are able to offset because of this limitation. That is what happened to me.
Furthermore, there are phase out provisions, too. This $25,000 limitation starts to phase itself out starting for earners of $100,000 on up to $150,000. This is making the $25,000 figure even smaller. This is also a problem for me.
However, one bit of good news is that the losses above and beyond the $25,000 carry over each year. Meaning, you are able to accumulate losses and can use them when you are able.
My Tax Plan Going Forward
OK, so after all this, what is my plan?
My end game has always been to “retire” early on the income from my real estate investments. What I would like to do is eventually quit my day job and truly do real estate investing full time. Once you are able to designate yourself as a real estate professional, the $25,000 limitation goes away. So, soon I believe I will be in a great position tax-wise. I know this to be true because I have built up a good amount of loss carryovers from years past.
At the end of the day, I am extremely grateful to be where I am and living in this great country. If you really take a 10,000-foot-view on this whole concept, it is remarkable to be able to legally knock down your income with legitimate deductions as far as most people do.
Paying a few thousand dollars in taxes when you have taken in substantial untaxed rental income throughout the year is amazing. Furthermore, taking advantage of items like depreciation on our properties adds to the extraordinary capabilities of this industry that we are in.
Taxes or no taxes, thank god for real estate and the U.S. of A.
[Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal or financial advice related to individual situations. Consult with your own attorney and/or other advisor regarding your specific situation.]
Any questions for me about the tax advantages extended to real estate investors?
Ask me in the comment section below.