Business Management

7 Common Myths About Rental Property Taxation—Dispelled

Expertise: Business Management, Landlording & Rental Properties, Personal Finance, Personal Development
65 Articles Written
rental-tax-myths

Time and time again, I see people asking tax questions and receiving conflicting answers. The confusion stems from our overwhelming tax code. Companies make billions of dollars helping you “simplify” your taxes with software and advice. One big box tax retailer is the top lobbyist for making the tax code more confusing so that you have a perpetual reason to buy their products.

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Frankly, I wish the tax code was simple. People like you could focus purely on business productivity. People like me would have to start businesses that add real value to the world (rather than adding value in terms of tax savings). I feel this plays into why I produce so much free content. I really want to break the tax code down for you as much as possible.

Today, I’m going to dispel tax myths related to real estate investors. I hope that you’ll find clarity with commonly debated tax items.

7 Common Myths About Rental Property Taxation—Dispelled

Myth #1: You must have a license to be a real estate professional.

This is a common question I see pop up over and over. Real estate investors believe that in order to qualify as a real estate professional, they must first obtain their real estate license.

In order to put “real estate professional” on LinkedIn, you may indeed need your real estate license. But to qualify for the real estate professional tax status, all you need is time.

For those that don’t know, qualifying as a real estate professional for tax purposes allows you to deduct passive losses generated from your rental activities that would have otherwise been suspended. For all my high earners out there, you know the pain of not being able to claim your suspended passive losses. The real estate professional status helps you get around that annoyance.

The rules are simple: Work 750 hours in a real estate capacity, and more than half of your time must be in real estate. You do not have to work on your rentals in order to hit the 750 hour requirement. You can be a full-time real estate agent, property manager, contractor, etc. and meet the 750-hour rule. However, you cannot have a full-time job unrelated to real estate and qualify as a real estate professional due to the "more than half your time" rule.

Those are all the requirements you need to qualify as a real estate professional for tax purposes. This is an annual election, so on January 1, your prior year hours are wiped out and you need to start fresh.

But here’s the catch. Once you qualify as a real estate professional, you must then demonstrate that you materially participated in your rental real estate activity. There are seven tests for material participation; the most common is the 500-hour rule. So aim for spending at least 500 hours on your rental real estate if you want to take passive losses that would have otherwise been suspended.

The key is to log and record your time as it relates to real estate. What type of activities should be recorded? I dive into that here.

first-note-investment

Related: THIS Major Tax Benefit Convinced Me to Put My Money Into Large Multifamilies

Myth #2: If you have passive losses from rental real estate and cannot take them, you lose tax benefits.

I get emails all the time from clients and non-clients questioning the true benefit of rental real estate if you can’t take the losses.

The good news is that if your rental shows a passive loss, you aren’t paying taxes on the rental income being generated. Hopefully, you actually made money and the passive loss is just a “tax loss” rather than a hard loss. If that’s the case, pat yourself on the back. You’re reducing your effective tax rate slowly but surely.

When you have a passive loss from your rental activities and cannot use the loss due to high income, what happens to those losses? They become suspended until they can be used to offset future passive income or offset the gain on sale of an investment property.

You do not lose the tax benefits. The key is that you lose the tax benefits today, but those tax benefits will be used at some point in the future when the suspended loss is released.

Because you can use the suspended loss at some point in the future, we want to continue aggressively writing off everything that we legally can. Oftentimes I hear that people stopped writing off travel, transportation, meals, and home office just because they thought there were no tax benefits in doing so. Again, there are no tax benefits today, but you will reap the tax benefits in the future.

Oh, and you can and should always write off depreciation. It will increase your suspended passive losses that are being carried forward, but if you don't write off depreciation, you will be in a ton of pain when you go to sell the property. Trust me on this.

Here is an article I wrote on creative methods of tapping into suspended passive losses.

Myth #3: Flipping income qualifies as capital gain.

Sorry, Charlie. This is the most painful news to break to eager tax savers.

Your flipping income will rarely be considered capital gain income regardless of how long you hold the property. The reason is you had intent to develop and sell the property—not develop, hold, and rent the property.

For folks wishing to achieve tax savings by qualifying their flipping income as long-term capital gain, you need to finish your rehab and then rent the property out for a period of time. Only then will you be able to justify the intent to hold the property for investment purposes.

If your CPA is writing your flips off as long-term capital gain income, give me a call when you get audited.

In this article, I provide you with tax court cases where investors have been burned on their flipping income.

Myth #4: Short-term rentals are reported on Schedule E.

This is sometimes false.

Regular rentals are reported on Schedule E, as they should be. However, short-term rentals could be reported on Schedule C like an ordinary business would be.

If your average rental period is less than seven days for your rental, you may be required to report your short-term rental on Schedule C. If your average rental period is between 7 and 30 days and you also provide substantial services, then you will report your rental on Schedule C.

It’s important to note that the Schedule C vs E debate largely rests on what services you provided to your tenants. Substantial services are those that are primarily for a tenant’s convenience include regular cleaning, changing linen, or maid service. If you provide such services, you may have a Schedule C property.

If you get stuck reporting a short-term rental on Schedule C the income won’t necessarily be subject to to self-employment taxes. Here is more information on reporting your short-term rental.

Myth #5: You can deduct costs incurred to rehab your rental units.

I always hate to be the bearer of bad news here, especially when it’s a client that we failed to inform.

You cannot deduct any costs incurred on your rental property until you place the property into service. Without placing the property into service, we are forced to capitalize costs and depreciate, generally over 27.5 years. Placing the property into service means advertising the property for rent.

The one exception to this rule is if you already own rentals in the same geographic location as the new rental you are rehabbing. If your current rentals in the geographic location rise to the level of a trade or business, you can deduct your expansion costs related to acquiring the new property in that same geographic area.

Placing the property into service during your rehab could allow us the flexibility to deduct some costs as operating costs (if they qualify) rather than being forced to capitalize and depreciate costs.

Capitalizing and depreciating the costs forces us to write off the costs over 27.5 years. Everyone should be able to understand that writing off costs today is much better than over 27.5 years.

But there’s a hidden benefit—writing off costs today rather than capitalizing and depreciating costs saves us money when we sell the property.

When you sell a rental property, you must pay “depreciation recapture” taxes generally equal to 25% of all the depreciation you’ve taken over the years. By capitalizing and depreciating our rehab costs, not only are we writing the costs off over a long period of time, but we must then pay a 25% tax on the depreciation amount that we have taken when we sell! Argh!

There are nuances to when you are allowed to advertise the property for rent. The property needs to be “substantially” complete, so we can’t advertise a shell for rent. Additionally, in order to deduct costs, you must consider the Tangible Property Regulations in that each Unit of Property within your building structure must be placed into service before the aggregate rental can be placed into service. So don’t think that we’ll be able to write off a portion of your rehab just because we advertised it for rent early in the process.

As an added benefit, thanks to the 2017 Tax Cuts and Jobs Act, you can now use 100% bonus depreciation on components with a useful life of less than 20 years. So if you keep track of your rehab costs and itemize your invoices, you can likely break out a portion of your rehab and classify components as 5, 7, and 15-year property. Doing so will allow us to 100% bonus depreciate the items in the first year the asset is placed into service.

master-lease-option

Myth #6: Using 529 plans is great for real estate investors.

I wrote an article that should have killed the notion that 529 plans are good ideas for investors and business owners here.

I received negative comments from people in the finance industry (surprise, surprise) and from folks who likely didn’t understand the strategy I was trying to demonstrate.

In fact, 529 plans are good investment vehicles for folks who want to save for college but do not own investment real estate or a business. Contributions to a 529 plan are generally deductible on the state level and never deductible on the federal level.

The problem is twofold: They stink in terms of tax minimization, and you can generally only withdraw funds for qualified education expenses without paying penalties.

I like flexibility. The 529 is inflexible. Thus, I advocate against the 529 plan.

Instead, we advocate for the use of Roth IRAs for college savings vehicles. You are able to withdraw Roth IRA contributions tax-free and penalty-free at any time. We don’t have to use the monies for a specific purpose, and we don’t get penalized if we choose to move the funds elsewhere. That’s flexibility.

A note on retirement plans: I am not advocating that you should tap into retirement plans. I am showing you a way that you can build wealth for your child and save for college while maintaining flexibility. This is also an “either/or” scenario—with the 529 or the Roth IRA. If you have the funds to contribute to a 529 and run the Roth IRA strategy I’m about to disclose, then use the 529 for college savings and the Roth IRA for your child’s future retirement. Otherwise, use the Roth IRA for college savings.

Here’s the strategy:

Hire your child to work in your business or on your investment portfolio. Pay them less than or equal to the standard deduction (currently $6,350). Transfer up to $5,500 of that payment into a Roth IRA in the child’s name.

You get a tax deduction for the payment to your child much like you would if you were to pay a contractor. Your child pays $0 taxes on the payment because children have a FICA exemption, and if someone earns less than the standard deduction, they don’t have to file a tax return.

So, you’ve literally created a tax-free transaction by moving money to your child. Additionally, your family wealth increased via your tax savings on the deduction you receive for paying for services/labor.

On top of that, we now have the funds in a tax advantageous vehicle, the Roth IRA. You know that you can withdraw the contributions tax-free and penalty-free. So, now you have a college savings fund, and should the child choose not to go to college, you have a house fund, wedding fund, retirement fund, or whatever else you want to call it.

But overall, you have flexibility, and to me, that’s priceless.

Related: Why Your Tax Strategist Should Probably Be a CPA

Myth #7: Following the BRRRR(RRR?) strategy allows me to refinance my property and continue to deduct mortgage interest.

The much-talked-about buy-rehab-rent-refinance-repeat (BRRRR) method is great for wealth building. It’s not great for taxes unless you have another property readily available to move the refinanced funds into.

When you refinance a property and take cash out, we must “trace” the cash to see where it is applied. When you let it sit in your bank account or if you buy some sort of personal item with the cash, the interest applicable to that cash becomes non-deductible from a tax perspective. We can only deduct interest on refinanced cash when it is applied to a rental or business activity.

So, you have a $100,000 home with $40,000 in equity. You find a lender who will lend 80%, so you lock that note up, leaving you with $20,000 in equity and $20,000 in cash.

The interest on the $20,000 in cash is non-deductible until you apply it to a rental property or a business activity. Please make sure you plan for this; otherwise, you’re missing out on easy money.

Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.

[Editor’s Note: We are republishing this article to help out our newer readers.]

Which of these myths is most surprising to you? Any questions about these tax items?

Please comment below.

Brandon Hall is a CPA and owner of The Real Estate CPA. Brandon assists investors with Tax Strategy through customized planning and Virtual Workshops. Brandon is an active real estate investor and a Principal at Naked Capital, a capital group investing in large multi-family projects and manufactured housing. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients.
    Christine Thilmony Flipper/Rehabber from Warsaw, IN
    Replied almost 3 years ago
    Excellent article! Definitely a keeper!! So with #5 does the labor used to get the unit rent ready need to be capitalized and depreciated also? What about labor paid to w-2 employees paid to get the unit ready before placing in service? Would it be expensed or capitalized and depreciated?
    Margie Kohlhaas Rental Property Investor from Algona, IA
    Replied almost 3 years ago
    At what age do you suggest paying your child? My child is 9 years old, but my accountant suggested waiting til she’s 12.
    Pedro Morais
    Replied almost 3 years ago
    Hi Brandon, great articles (as always). Regarding refinancing, you mentioned it needs to be applied toward another rental property or business purpose. If I refinance a rental property and use the money to buy a multi-family property with 3 units as my primary residence and rent out the other 2 units would that count fo interest deduction? Thanks
    Sylvia B. Rental Property Investor from Douglas County, MO
    Replied almost 3 years ago
    “The one exception to this rule is if you already own rentals in the same geographic location as the new rental you are rehabbing.” How same is “same”? Next door? Same block? Within a mile?
    Robert James from Hermosa Beach, California
    Replied almost 3 years ago
    Brandon, I understand the concept that suspended passive losses can only be used to offset gains on other passive activities. What I don’t understand is if I earn interest income from making a loan to a business partner’s LLC — an LLC in which I do not materially participate – can I use real estate passive losses to offset this?
    Shea Spinelli Rental Property Investor from Tyler, TX
    Replied almost 3 years ago
    Great article! Does anyone have the IRS code for myth number 5? I have a ‘not in service’ property and 12 others on the same lot. I’d like to confirm the code prior to taking the expense rather than capitalizing. Thank you! Shea
    Angel Sanchez from Greer, SC
    Replied over 2 years ago
    Hi Brandon, thank you for the article; a question on Myth #5. I turned my detached garage into an apartment. During rehab, I advertised and got tenants lined up to rent the main house after I moved to my detached-garage-turned-apartment. Would the costs that went into rehabbing the apartment count since it’s in the same property?
    JL C. from Walton, West Virginia
    Replied 8 months ago
    Great article! I have a question related to “ Hire your child to work in your business or on your investment portfolio. Pay them less than or equal to the standard deduction (currently $6,350)...” Does this same strategy apply id it’s my grandson rather than my son? All my children are grown but I would like to get the grandkids involved if I can. Thanks! JC