Wondering how to minimize taxes owed to IRS from rental properties
We have 3 rentals, and Turbotax says we made about $27k off the 3 combined last year, so I ended up having to pay the IRS $8k. Currently the tenants pay us directly to our bank accounts.
Would we owe less if we set up an LLC (s corp?) and had the renters pay the LLC? Open to any ideas.
We live in Texas but all the rentals are in Washington state, if that matters.
For myself, I wouldn't bother setting up a trust or escrow account. Its just funds sitting with my "reserves/savings" --- whatever you want to call it.
If you manage your money by account, then by all means create another savings account, or whatever account you use. (personally, I use a brokerage account so I can get the pretty risk-free 5.25% in a money market fund that is completely liquid).
To be blunt, if you really are limited in funds... Then, the first tier of funds to have on hand is for repairs and smaller repair/replacments. For example, a leaky faucet or toilet. Nowadays a plumber costs a bit, but you need to have "$100's" handy. Every 7-10yr'ish you need to replace a water, or whenever it goes, so maybe $1500. Since you have three properties, if you can afford to have ~$5k handy in case all three go at once that would be nice. But what are the chances --- until it happens LOL
Of course, you need to save up potentially for some vacancies... Hopefully, you don't have all three go vacant at once.
Then, you need to have a plan for larger expenses such as a new roof, driveway, etc. Granted, if your plan is to swap properties before major capital expenses, that makes it easier --- pretty standard plan.
Otherwise, just use whatever investment plan you have for the extra cash flow. You need something to complement real estate since its usually done in large chunks of money.
Good luck.
@David M. Thanks, but my question was from the perspective of having these reserves counted as deductible expenses (since is prudent to keep them available) and lowering the tax footprint, as mentioned by @John Clark.
But since you mentioned how to calculate them, this how we do it - I have a google spreadsheet that tracks all the times, with their considered lifetime expectancy and the date the item was placed in service. It's "live" as it updates behind the scene everytime you look at it, since various items might reach their lifetime expectancy and, based on that, should be replaced (obviously, they can fail much sooner, or last much longer than that).
Using that spreadsheet I know what how much I should save in capital expense for each property every month, per year, which ones are past their lifetime and due for replacement, and a total for all properties (if all was to fail at the same time). Obviously, I'm not keeping that large of amounts, but it can add up pretty quick to large amounts. Even if you keep just 20% of expected amount and it's still a good chunk of money to hold in reserves.
Quote from @Costin I.:The IRS has tests for excess. Certainly the spreadsheet you created and the funds there will help justify your reserves. Figure your “catch up” contributions to reserves and then annual contributions on top of that. You also need reserves for vacancies, general emergencies, etc.
@John Clark @David M. - what would you consider "excessive" (or how would you calculate allowed reserves) and how would you set up such a trust or escrow account?
so the real take away is that you did not make $27k on those properties for the simple reason that you failed to adequately calculate your expenses.
a labeled account for reserves shows your intent and helps justify your deduction. Just make sure that when you withdraw from the account you count it as income.
Oh, yes I definitely misunderstood.
However, I don't believe what you are asking about applies to cash accounting methodology. So, to do what you are asking, make sure you are using the appropriate accounting method. Good luck.
@John Clark, I don't think you can count cap ex reserves as an expense and deduct them. I asked this specific question in this post and 2 accountants weighed in on the issue. Please provide some more info if something like this is still possible.
Quote from @Costin I.:If CPAs are telling you otherwise then follow the CPAs, not me. I have defended the deductions by showing that the money was placed in trust accounts and cannot be accessed except for the permitted expense. Once done, however, the withdrawn money became income.
@John Clark, I don't think you can count cap ex reserves as an expense and deduct them. I asked this specific question in this post and 2 accountants weighed in on the issue. Please provide some more info if something like this is still possible.
As CPAs will tell you, you are supposed to put your depreciation into an account so that the money will be there to replace the asset. Nobody does, but one “should.”
@Costin I. yeah, it looks more like an accrual or similar accounting method. The "big/corporate boys" do that sort of accounting. I'd ask Plaks perhaps about that, or your own cpa/accountants. You don't run into this normally on this board.
Quote from @John Clark:And please keep in mind that your deduction after spending the money is the amortized cap ex expense—you put a new asset into service and have to amortize it over your 27.5 years or whatever. You can also take a further deduction for rebuilding your now-depleted reserves, but that has to be over a reasonable period of time as well.
Quote from @Costin I.:If CPAs are telling you otherwise then follow the CPAs, not me. I have defended the deductions by showing that the money was placed in trust accounts and cannot be accessed except for the permitted expense. Once done, however, the withdrawn money became income.
@John Clark, I don't think you can count cap ex reserves as an expense and deduct them. I asked this specific question in this post and 2 accountants weighed in on the issue. Please provide some more info if something like this is still possible.
As CPAs will tell you, you are supposed to put your depreciation into an account so that the money will be there to replace the asset. Nobody does, but one “should.”
So you will be paying tax on ordinary income to the extent you pulled money out of the (properly established and safeguarded) reserve account less the amortized expense and a smallish deduction for that year’s contribution to rebuild reserves.
The fact that the money was all spent on the capital expense is your problem—you have to use another pocket to pay your now-increased income taxes. There’s no free lunch. There is, however, if properly managed, a distinction between building reserves and funding depreciation.
Oh, and when you sell the property, unused reserves become ordinary income, and you pay the hit.
I suspect that I am one of the few small timers who actually funds both his depreciation and his general reserve.
Quote from @Brian Hunsaker:
We have 3 rentals, and Turbotax says we made about $27k off the 3 combined last year, so I ended up having to pay the IRS $8k. Currently the tenants pay us directly to our bank accounts.
Would we owe less if we set up an LLC (s corp?) and had the renters pay the LLC? Open to any ideas.
We live in Texas but all the rentals are in Washington state, if that matters.
i did a 1079 on a kubota for 35k one year, cost me $300 a month- wit the 8k that pays 2 1/2 years of payments and use te 8k as a down instead of giving to the govt.
doesnt work everytime but if you are continuing to buy and hold its completely doable.
Going to clear up a few things here:
1) Cost Segregation Study (CSS) makes sense for large commercial properties. I've never heard of it being used for residential rentals. The study costs $3k and up - it would have to identify a lot of depreciation.
2) You cannot deduct the money you place into reserve accounts until the year in which you spend it. Getting a tax preparer to take an aggressive position on a return is not the same thing as what the ultimate correct position will be if you are audited (plus interest and penalties). You can't mix accounting methods by expense. When your rental income and deductions are on Schedule E you deduct in the year you pay, period.
3) Read through the IRS Publication in Rental Income and Expenses make sure you are keeping records and deducting everything you can. https://www.irs.gov/publications/p527
4) If you spent 250 hours over the course of the year on matters relating to the properties you can take the QBI safe harbor which deducts 20% from your final after-expenses number.
There are other areas to look at in your tax picture that can impact the amount you pay over (your top tax bracket). Are you getting as much income as possible into tax-deferred retirement accounts? Would a HSA help? Are you filing married/jointly and is that the best election - sometimes if you're rich spouse/richer spouse you can file separately and allocate income and itemized deductions with the other taking standard deduction to save overall.
This is where the rubber meets the road on Turbo Tax vs a CPA who has experience helping people in the top brackets. Turbo Tax does fine adding up what you owe the IRS. But it doesn't meet with you at the end and tell you how to save $10,000 next year.
@Melanie P. - CSS makes sense for smaller 1-4 properties too (150K-1.5Mil) and one can do it using KBKG.com or DIYCostSeg.com for ~$500. At that price is feasible and good enough for the small investor needs.