De-Mystifying Your Tax Questions on Real Estate Investing

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As both real estate investors and tax strategists, we have been working with real estate investors our entire professional careers. It’s amazing how much has changed over the past decade. Very often our new clients would get themselves involved in real estate deals as a way to begin building some passive income towards retirement. Most investors know that real estate investing comes with some GREAT tax saving benefits. However, a lot of people are often confused as to what tax loopholes they can actually use and just exactly how to use them correctly. Of course, it’s no wonder that a lot of people are frustrated when it comes to taxes and real estate. The US tax code is one of the most complex in the world and it just keeps getting more complex by the day. The tax laws have changed so much over the years that many people are confusing new laws and rules with outdated and incorrect ones.

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Myth vs Fact

I wanted to take this opportunity to clear the air with some of the most common misconceptions when it comes to real estate and taxes to hopefully provide you with some guidance on maximizing your tax benefits:

Myth: You can write off all of your real estate losses on your tax return.

Fact: The answer is yes and no. Although you can capture all of your real estate expenses on your tax return, you may or may not actually get an immediate benefit on those expenses to offset your current tax liability. There are a number of strict rules that determine how much you can write off against your tax return and when your real estate expenses will actually offset your tax liability. See the next example on how you can potentially deduct all of your real estate losses.

Myth: Anyone investing in real estate will qualify as a Real Estate Professional (REP) to deduct all of their real estate losses.

Fact: The Real Estate Professional status is a great tax loophole that allows investors to bypass myth #1 and to be able to take unlimited tax write-offs on their investment properties. However, there are two rules you must meet before you can qualify as a Real Estate Professional.

First, an individual must spend more time on real estate activities than non-real estate activities during the year. Second, an individual must spend more than 750 hours during the year involved in real estate activities in which the individual materially participates. Remember, you must meet both requirements to qualify as a REP. On the other hand, there is a misconception that in order to qualify as a real estate professional, one must have a realtor’s license. That is a false assumption since there are no licenses that are required for a taxpayer to receive the benefits of being a REP.

Myth: You cannot write off the entire purchase price of improvements for your investment property. It must be capitalized and depreciated over its useful life.

Fact: This actually depends on when you made the improvements for your property. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 provides a temporary 100% bonus depreciation deduction for certain types of improvements made to qualified improvement properties placed in service after September 8, 2010 through December 31, 2011.

Myth: You can’t claim a home office deduction if you own real estate because it is a red flag for IRS Audits

Fact: This is not entirely true. There are certain rules and guidelines you must meet before you can claim a home office deduction. You may take a deduction for home office expenses as long as the space you claim is exclusively used for business (i.e., a separate room, not your family room) and you regularly do some type of business in that space. If you own a real estate business or invest in a number of real estate properties and manage over these properties in your home office, you may qualify to take this deduction. As long as you qualify for this wonderful tax loophole, why not take advantage of it?

Stay Informed

It is clear that there is great value in keeping yourself educated and up to date with law changes. This could mean savings of hundreds to thousands of dollars to you year after year. Take for example the Unearned Income Medicare Contributions Tax for this year. This new tax is assessed on Net Investment Income such as rental income for another 3.8% on top of all the regular taxes you already pay!  Of course, we are already working diligently to come up with creative tax strategies to minimize or eliminate this new tax burden for our clients. Be sure to work with your advisor to ensure you are aware of the new changes. Ask them to help you plan and strategize so that you can avoid these taxes when the time comes too.

Photo: JD Hancock

About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

25 Comments

  1. Hi Amanda, Here’s a demystification need:

    – what entity type offers the most tax advantages to a wholesaler who has a lot of marketing expenses, driving miles to look at props before purchase, then marketing expenses after purchase.
    – Figure $100k short term gains from wholesaling activity
    – Figure REP status is true.

    I’ve felt the type S corp (or LLC with type S tax status election) was better than a DBA, LLC taxed as a pass through, or no entity where short term income is ordinary.

    Thanks, curt

  2. Since land cannot be depreciated, buying buildings in those state where land is cheaper, will have a n advantage. Such as farm country like Wisconsin.
    Also, for extra deduction, go for component depreciation.

    • Kris, was your comment a demystification answer?

      Googling component depreciation, this link says it was phased out in 1986 and replaced with cost segregation. To my reading, the catch in the IRA guide for cost segregation is: “The IRS and ATG require a qualified specialist to prepare a cost segregation study “, so I’m guessing me at the keyboards of turbo-tax business is not going to be able to use cost segregation for my rental house depreciation.

      A demystifiation question I have: is depreciation net net good or bad when you sell and have to reconstitute past depreciation taken. I’m a big picture type and like to know through the life of an investment how things work and what choices make for net higher returns.

      curt

      • Thanks for clarification on component depreciation.
        Depreciation is great, take as much you are entitled to. Half of my properties, plan to keep for ever, and let heir take it at new base than. Other half, being TIC’S, have little control, since 25 investors, prefer to keep that for ever too. If investors decide to sale, will buy other 1031 Exchanges, and delay any taxes.

  3. stuart Stevens on

    I would be interested in strategies to minimize federal and state tax legally. I live in California with the highest income tax of any state and would love to reduce that tax.

    Thanks

  4. Jeff Brown

    Hey Guys — Depreciation, in my experience, is one of the least understood and underutilized tool in the investor toolbox. Examples are probably a bit broad to mean much, as so much is dependent upon specific taxpayer circumstances. Suffice to say that providing tax shelter for cash flow and ordinary income aren’t all that’s in play for a large minority segment of the investor population. I’ll probably write some on it this week. Good stuff in this post for sure.

  5. Does anyone in the inland empire of southern California have any real estate centered accountants they could recommend? It’s hard enough learning and doing the business of REI. I don’t want to wear the accounting hat as well. We in California need all the help we can get!

    • I am in California, but use depreciation of real estate to my benefit. If, you own enough real estate, you can depreciate multi-family for 27.5 Yrs and commercial, say an Office Building for 39 Yrs, and more with cost segretation. You can even go to negative income, depending on your other income.

    • Hi Jeff, I am a RE investor / Private Lender in the IE, our office is in Rancho Cucamonga. I agree with you its better to focus on the business than the accounting side. Amanda the writer of this article is a CA CPA, we have been working with her for some time and she works with many other RE investors, I highly recommend her. This sounds like an ad, it isn’t, you asked the question Im giving you an honest answer.

      Amanda, nice to see you here, welcome to BP.

  6. My understanding on “segregation” in in it’s simpler form is that you can deduct appliances more rapidly (i.e. 5 years vs. 27.5 years). If there is something more complex than that I’m not aware of it. I’m thinking you can also deduct landscape improvements at a different rate.

    As per SCORP vs. LLC I’ve heard good RE accountants say that an accountant who recommends a buy and hold income investor set their biz up as SCORP should be charged with malpractice. I don’t know that this is true but there are some “taxable events” that can inadvertently happen if you go SCORP. (i.e. when you deed a prop from yourself to an LLC or SCORP for example) – IMHO using SCORP can be a great tool for business in general but it adds a couple of layers of complication so it’s ultra important to get personally clear on the benefits first.

    • Guys, depreciation is nice but really not all that – think about this. I replace 5 stoves in 5 units; costs me$2,500. I get to depreciate this – nice. But, I have to wait for 7 years to recapture – that sucks if you think about it. I spent the money now – why not let me depreciate it this year?!

      We certainly benefit relative to taxation from depreciation – granted we are better off by far than, say, earned income people. But, it could be much, much better…

      Never buy because of tax benefits. Buy for Cash Flow!

    • In my limited understanding of cost segregation studies, you reclassify various parts of the unit under faster schedules (instead of the standard 27.5 year schedule). Some things move to 5 years, but others are 7, 10, 15 years, etc. This is where you need the right CPA who understands this stuff. Mr. H & R Block at Walmart will NOT know what you need. They will look at you with deer-in-headlight eyes if you bring up cost segregation. They might not even understand plain depreciation.

      But the other factor in all this is that you need the right CPA who can analyze your entire situation, and help you decide if it’s right for YOU. I have a friend that paid off their old home, bought a new home, and now rents out their old home to pay for the new one. He makes 1/5 the W2 income I do. His depreciation needs and uses are totally different than mine, where I own two duplexes and actually make too much money to apply any depreciation to my W2 income.

      A buddy of mine had his father-in-law recommend not taking any depreciation. I stared at him, and point blank told him that was probably wrong. Without hesitation, I gave him my CPA’s name/number, and suggested a free phone call might provide more information. I told him that if he ever sells his rental down the road, the IRS will treat him as if he depreciated, which could result in a nasty tax bill. If he got no tax credits in the beginning, it would be a double whammy. Beyond that, I really told him he needed to talk to a professional that understood this stuff, and my guy did.

      Experts can be great, but they are needed to not only do the procedure they do, but advise you IF it’s right for you. That is what makes it hard to find the right expert.

      My initial CPA kept pushing me towards qualifying for Real Estate Professional status, when I knew there wasn’t a snowball’s chance of me qualifying. The CPA I have now is perfect for my needs, and we just wrapped things up a couple weeks ago. He performed cost segregation studies, and we now have some tasty unused depreciation started to collect on the shelf, which I plan to dip into when I sell my first unit.

      Happy RE investing!

  7. Wow….thank you everyone for the comments and the wonderful add-ons that a lot of you added here. It is great to hear everyone’s experience with respect to cost segregation, real estate professional, dealer status, etc. etc. The best point made above was that all the “strategies” and “pitfalls” apply in different ways to different taxpayers. So while doing a cost seg may be great for one investor, it may be a huge waste of money for another. Believe it or not, even being a real estate professional may have pitfalls in certain limited instances. The main thing is to work with an advisor who understands your real estate business. In my years of working with real estate investors I can say without a doubt that RE investors are some of the most creative people in the world!

  8. Are federal and state taxes included in addition to the capital gains tax and the Net Investment Tax? I’m mainly gonna flip and go sole proprietor….and capital gains on anything held less than a year is 35%, correct?

    • Hi Jorge:

      Yes Net invest tax is in addition to federal and state income taxes. If you are flipping properties however that is generally considered ordinary income and not investment income so you may be able to avoid the net investment tax. On another note, I highly suggest you speak with your tax advisor on entity structuring strategies as you can probably generate some significant tax savings by not operating as a sole prop in the future.

  9. Amanda, thank you for your prompt reply…I’m listening to your podcast as I type…I was told that sole proprietor was always the best way to take title b/c you can get the most deductions that way…If I’m wrong on that, please enlighten me and I’ll definitely have to find a tax advisor here in the city that also knows real estate

  10. Robert Brockman on

    does anyone know if on real estate if you have to pay taxes on your original perches price. for example you paid 150,000.00 and sold for 300,000.00 do you have to pay on the 300,000.00 or do you only pay on the money you earned

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