I had lunch with a customer yesterday, who, with no prompt from myself, began telling me about all of the homes he had owned. The last one, he put up for rent the last year they owned it. His comment was "they really nailed me on the income tax return because of that"... I asked if he meant on the rental income and he said yes. This all followed by the ever common "I'll never do that again" that I hear from people who take a failure as a sign to quit completely.
I know there are many different reasons this could have happened, if it did, and not many details were provided. However, with so few details, what could have been a reason for his poor experience with owning a rental property? He did say he ran it by two different CPAs to make sure it was correct.
What are the ways you can make sure you pay too much in taxes on rental income? (So these mistakes aren't repeated)
Your post isn't really clear. You want to pay more in income tax? Or perhaps you purposely framed it in the negative?
If you want to pay the least amount in income tax, your best bet is either (1) tons of self-education or (2) start a long-term relationship with a tax advisor who has experience with fact patterns like yours.
We could spend all day speculating about why your friend said he paid a lot in taxes (perhaps he really didn't but was just making conversation). No one really knows unless they examine his returns. Maybe it wasn't the rental, but rather something else.
You are correct, I purposely framed it in the negative.
For a rental property, one way to pay more taxes is to not do 1031X upon sale. As depreciation recapture is taxed at a higher rate than long term capital gains, taxes owed via depreciation recapture would exceed the taxes saved over the years via depreciation loss.
I think this is the main reason people do 1031X. Their ego doesn’t allow them to say that Uncle Sam has them by their jugular, so upon doing 1031X they claim they didn’t have to pay (they don’t use the word defer) any taxes - which is better than saying that they will never realize the gains ever (until they die) and would have paid more taxes than saved if they wanted to realize the gains. Most of the time they have to overpay to defer the taxes as good time to sell is not a good time to buy. So the decision has to be whether they overpay for a new property to defer taxes, or realize the gains and pay more taxes than what was saved. Uncle Sam is always the winner.
@Tushar P. I do wonder if he meant the taxes on the sale, rather than his rental income.
Essentially what you are asking here is a list of mistakes, financially speaking, when dealing with rental properties - at least that's how I read your post. That could take an entire book for sure (and there's a decent BP tax book available here), but a few things off the top of my head:
1. Not taking advantage of actual tax advantages that real estate gives you that are essentially "mandatory". For example, if you don't take depreciation on the property each year, that's too bad, so sad for you when you go to sell it 20 years from now because you are going to recapture the depreciation you were supposed to take.
2. Not optimizing your expenses - for example, if you know you are already maxed out on your passive activity losses, and you have your property taxes coming up to pay, you can lose the value of those write-offs by using them when they won't count any more (you may be able to carry losses forward but I'm trying to keep this simple) instead of paying them when it makes sense, tax-year speaking. So, for example, in my case I get my tax bills in September or October for the municipalities in which I own homes. Almost all of these give you a tax deadline of Feb 28th of the upcoming year. If I need tax deductions this year, I pay them now. If I'm already maxed out, I hold them until after Jan. 1 since you generally take deductions when you pay them. So some years (this one, for example), I pay property taxes twice in the same calendar year because it's more advantageous to my situation.
3. Depreciating items/expenses that tax law exceptions may allow you to write off in one year - or, vice versa, if you know you're going to need deductions 5 years from now. Some of the tax laws, like safe harbor, de minimus, etc. sometimes give you options to take a normally full-life depreciation item now instead of over 5,10,20 years. You have to know where you stand with your tax bill to know what's the smarter move.
Those are just a couple that I can think of right now.
@JD Martin you understood exactly what I was doing. Thank you for your reply.