7 Common Myths About Rental Property Taxation—Dispelled

by | BiggerPockets.com

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.

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 false (most times).

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

The reason is related to the transient basis rules. If a rental unit has an average rental period of seven days or less, it is considered transient. If the rental unit has an average rental period between 7 and 30 days and substantial services are provided, that rental unit is transient.

If less than 80% of your gross rents on a property come from long-term tenants, you have a non-residential rental property.

So, if you have a vacation home and all tenants stay on average for seven days, then 100% of your rental income is coming from short-term tenants. Thus, you have a non-residential rental property.

On the flip side, let’s say you have a multifamily property where you generate $80,000 from long-term tenants and $20,000 from short-term tenants. Here, you meet the 80% test, so you have a residential rental property.

The difference between residential and non-residential is key. Residential rental property is reported on Schedule E. Non-residential rental property is reported on Schedule C.

Schedule C subjects your income to self-employment taxes. Yikes! Here is more information on reporting your short-term rental.

I rarely include citations in my blog posts, as I try to keep them as non-technical as possible. However, if you (or your CPA) would like to see references, connect with me and I’ll show you what you don’t want to see!

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. You are then considered to already be operating in that general location, and thus you have flexibility in deducting your rehab costs rather than capitalizing without having to advertise the new property first.

Please folks, only listen to your qualified professionals on this matter. Do not trust the word of property managers, real estate agents, contractors, etc. Have your facts analyzed by a tax professional prior to engaging in any tax reduction strategy.

The benefit of placing the property into service prior to engaging in a rehab is profound. Doing so will allow us the flexibility to deduct costs as operating costs (if they qualify) rather than being forced to capitalize and depreciate the 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 “deprecation 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 and think that all rehab costs will be deducted.

But we can definitely advertise the property for rent prior to painting—prior to appliances and granite countertops, prior to fixtures and lights.

Our clients tend to be surprised when we tell them, “Don’t rehab your property without letting us know the plan first.” But the reason for our request is simple: smart planning = tax savings.

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.

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

Please comment below.

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

77 Comments

  1. Llewelyn A.

    Hi Brandon,

    Thanks for writing this great article!

    Just curious if you would know if there are drawbacks where, once you allow yourself to become an Active Real Estate Professional, while it’s great on the part which allows you to deduct your losses, by the time you are generating positive income, you will be hit by Self-Employment Taxes? That could take as much as an extra 16.5% hit on your bottom line.

    I’m not a tax professional, but I have always been curious whether the change in status from Passive to Active later on down the road will hurt you. Or can you just change your status when convenient to do so?

  2. Joe J.

    Great, great article! Question on item #5: we’d placed tenants (who had not yet moved in but agreed to do so in a couple of months) before rehabbing. The unit was never advertised but rented via word of mouth (arms length, not a relative or personal friend). The tenants visited prior to the rehab to be sure that they wanted the place, and even chose paint colors, etc. for us to use in the rehab. Is this sufficient to qualify as “in service”?

  3. Adam Bezark

    Excellent ideas! Regarding the ROTH ideas, it might be a good idea to explain/emphasize that you are referring to the contributions portion only of one’s ROTH, not to be confused with any earnings also in the account.

  4. Paul Ewing

    Brandon, I haven’t heard this before:
    “The one exception to this rule is if you already own rentals in the same geographic location as the new rental you are rehabbing. You are then considered to already be operating in that general location, and thus you have flexibility in deducting your rehab costs rather than capitalizing without having to advertise the new property first.”

    What do they consider the same geographic location? Same block, a couple blocks, a couple miles, same zip code? This could be a big deal for me. Most of my places just need lipstick rehabs (new floor covering, paint, and fixtures) and sometimes I have a tenant before I get the home started, but if I do a larger rehab it will be useful. Does it still have to be under the de minimus safe harbor limits?

    • Brandon Hall

      Geographic location is defined in the travel rules:

      “The geographic limits of the official station are the corporate limits of the city or town where the employee is located, or, if not in an incorporated city or town, the reservation, station or other established area having definite boundaries where the employee is located, not to exceed 50 miles from the employee’s location.”

  5. Jason Starr

    Very helpful article, thanks for the tips Brandon!
    One question, if you have suspended passive losses and then are able to file in a subsequent year as Real Estate Professional, are you then able to deduct those suspended passive losses from the past against current non passive W2 income? Or do you have to wait till you sell a property or you have passive income that exceeds loss to deduct the suspended passive loss?

    • Brandon Hall

      Prior year suspended losses will remain suspended. The only way to activate them is to have passive income or sell the property. Unfortunately, claiming the RE pro in later years will not activate prior suspended passive losses.

  6. Paul Allen

    “Please folks, only listen to your qualified professionals on this matter. Do not trust the word of property managers, real estate agents, contractors, etc. ”

    One Thousand Times, YES!
    I was developing a very negative opinion of real estate agents before I joined BP. So many clients telling me things their REA said that just aren’t true.

    The REAs participating here have done a lot to restore my faith. 🙂

  7. Michael Swan

    I love it!! I did withdraw from my deductible IRA, paid the stupid tax (10% penalty) for even investing in those things of I call MYTHS for financial freedom and also paid the taxes due, one property at a time as I explained on Podcast 238 as a guest with Brandon Turner and Scott Trench. Fast forward 6 years later, now have $160,000.00 cash flow, which recently has risen from $120,000 cash flow. Started with 10 condos in San Diego this way and have now traded them in for 7 apartment complexes in NE Ohio. Net worth now at approximately 5.5 million, 2.5 million in net worth and that $160,000 cash flow per year moving forward!!

    If I would have kept that money in my IRA, I would have invested in small cap, mid cap, large cap, international, and fixed, DEWORSIFIED PORTFOLIO. Now I am getting money in my pocket every month and not at some imaginary age in the future!!!

    Buy based on cash flow, not losing money, use the power of the 1031 exchange your way to financial freedom!!! Defer, defer, defer, defer, defer, defer, and die with over 1000 doors and your kids inherit at a stepped up basis and they could have 5000 front doors someday and stay with the same plan.

    That is how you create truly long lasting multigenerational wealth. Also, it sure feels great going to my 9-5 job knowing I am financially free, giving me a whole new perspective on working for money!!! My money works for me, even when I am sleeping.

    Find a great RE CPA, read LOOPHOLES OF RE by Garrett Sutton and take advantage of all the IRS regs available to us as RE investors.

    Remember, it must cash flow and mitigate as many risks as possible, capturing equity at purchase. This way you are stacking the cards in your favor for single family.

    With true multifamily (5 units or more) be very careful!!! This is not intuitive and an entire different ball game than single family. It has tremendous upside potential if you know what you are doing and learn from someone that has vast experience in this sector. I would consider going in as a passive deal on your first one or two Multifamily deal, with someone that will teach you all the pitfalls. There are many that I learned the hard way through the life of hard knocks!! You don’t have to.

    YOU CAN DO IT!!!! If you change the way you look at things, the things you look at change right before your eyes!!!

    Go to my profile and reach out to me if you are thinking of following my path outlined on Podcast 238.

    Swanny

  8. Joseph Walsh

    Thanks for this. One question on #7(actually, 1+1). Using your scenario, Assuming all, or a portion of ideally, that $20,000 on cash-out refi is use to pay off hard-money or other private loans used to purchase the property to start with, what’s the proper way to “trace” that to not pay taxes on it (or only pay on the partial assuming you profited on it). And for the +1 on that, can you include the interest on said hard money/private loans as part of the total, or is that an “interest” deduction? So, lets say, I borrowed 15k, cashed out 20, and paid back $15k, plus interest and fees of $1k , do I trace $16k of the 20 as acconted for, or do I have to account for the $1k separately as “interest” or some other category.

    Thanks,

    Jay

    • Brandon Hall

      Hi Jay – I don’t have all the facts, but generally yes you’d be able to deduct the interest on the $16k as it was applied for investment/business purposes. The interest on the remaining $4k of your cash out is non-deductible unless applied for investment/business purposes.

  9. Katherine S.

    @Brandon Hall Thanks for the interesting list. Could you clarify a point regarding Myth#5…does “putting into service” have to happen prior to rehab in real time, or within a calendar year as in before you file your income taxes? What is the point of this rule, anyway?

    • Brandon Hall

      Hi Katherine – if you do not place the property into service, all costs incurred prior to that are considered “get ready” (not a technical term) costs. Get ready costs are capitalized and added to the basis.

      By advertising the rental for rent, you are placing it into service and effectively beginning operations. Once you begin operations, some of your rehab costs may be deductible as operational costs (instead of being forced to capitalize as get ready costs).

      The year in which you place it into service does not matter. It’s all about the date you advertise vs the date costs are incurred.

  10. Curt Smith

    Hi Brandon, excellent. Also #5 you didn’t mention that the rental rehab prior to renting in service date adds the rehab costs to the cost basis of the Sched E house. Minor nuance, that doesn;t affect the current tax year.

    Very interesting re the BRRR cash out REFI interest from the REFI date onward. LOL bet everyone including me has deducted 100% of that new higher interest on that Sched E. 🙂 Learned a bit. tnx.

    • Brandon Hall

      Hi Curt – I did here:

      “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.”

        • Brandon Hall

          Hi William – it needs to be “substantially complete”. So when a client picks up a new property and they plan a rehab, we ask them to send us their plans. We want them to do the major things first – the things that we wouldn’t be able to deduct regardless. By the point those are done, the unit is likely livable, thus substantially complete. Then it’s all about advertising it for rent.

  11. Steve Johnson

    Thanks for the great article! I love the concept of the ROTH vs the 529 – I would assume you could only do this a few years though as your children would have to be a minimum age to “work” – or is there a way to begin this with, say, a toddler?

    • Brandon Hall

      Tax court cases indicate age 7 is the minimum, however only because that’s the youngest on record.

      I always say – the Gerber baby got paid. If you can make a compelling reason for a toddler to be in your business, go for it. Speak with a tax advisor first!

  12. Ariel Cohen

    Brandon,

    As far as being qualified as a real estate professional, If I work “full time” for a property management company that is managing their own real estate, can I be qualified as a real estate professional or does it have to be work for my own portfolio in order to qualify?

    Thank,

    Ariel

  13. John Murray

    All my rentals are in the same zip code and within 2 mile radius of my house. My BRRRR biz makes about $250K per year in rent profit and refinance. I keep my CPA on speed dial, he has to figure out how to plan my exit strategy. He is worth every dollar I pay him. If you are a serious investor you need a wealth building CPA and a wife with an MBA. I’m just an electrician that understands building trades and I’m really good at that. I rely on experts to reduce my taxes.

  14. Stacey Roberts

    hi thanks for that great article!
    a questions re passive losses. Do I have to sell my interest in all my real estate to be able to use the passive losses . For example if I have 6 properties that I have accumulated passive losses against and I sold two of them can I use any of the passive losses or would I have to sell them all to be able to use the passive losses. The partnership LLC contains all the properties at the fed level but not at the state level.

    • Brandon Hall

      When you liquidate a passive activity with a gain, the passive losses can be utilized to offset that gain.

      So you could have 6 properties all producing passive losses. You could liquidate one property and the losses from the other properties can offset the gain on the liquidated property.

  15. Andrew Merritt

    Good Article. I’ve got a question about #7. I’m buying a duplex for $175k cash (my first rental property), then doing delayed financing afterwords (somewhere between 70% to 80% LTV). Will I not be able to deduct the interest from my taxes unless I buy another property with it? I was planning on buying another house (if I find one) or throwing it into index funds.

    • Brandon Hall

      Hi Andrew – yes, this is a major flaw with the purported BRRRR strategy. The interest on the cash that hits your bank is non-deductible unless reapplied for investment or business purposes.

      Ex: You buy cash for $175k. You then “cash out” $122,500 and it sits in your bank. You cannot deduct the interest on that $122.5k until reapplied.

  16. Danish New

    Hey Brandon,

    Great article thanks!

    I do have a quick question:

    What if you are a full time employee (W-2) and have done a couple of flips under an LLC and incur a losses in the current year. Could you deduct those losses against your W-2 income?

    Thanks again!

    Danish

  17. John McAuley

    Very helpful article. If you have suspended passive losses carried over from previous years, can you take all of those in the first year you or your spouse qualifies as a Real Estate Professional? This is assuming you have high enough income to use them. For example, if I have $100K in suspended losses accumulated and my wife qualifies next year as a Real Estate Pro, can we use all of those losses to offset my W2 income next year? Thanks.

  18. Eric Peterson

    Thanks Brandon. For #5 is it possible to deduct expenses for a property I don’t own yet. For example I’m buying a home and want to install ceiling fans right away so I would like to order them in advance. I will be advertising the home before I own it and I already own other homes in the area. Just curious about a prior to owning expense? T

  19. Hi Brandon,
    Myth #4: Can you tell me where I can get support for the 80% test that you mention (short-term vs long-term tenant). I can find support for the 7 days vs 30 days and substantial services in the IRS Publication 925, but nothing for the 80% test you are referring to. I’m sure it’s right in front of me and I just don’t see it. Thanks!

  20. John Rives

    Brandon, I really enjoy your articles, I always learn something, and go back and revisit them often. I have a depreciation recapture question that I can not find an answer to online, nor from my (feeble) attempts to uncover in the IRS worksheets.
    Q: Do itemized deductions and exemptions offset “income” from depreciation recapture (higher tax rate) before taxes owed on capital gains (lower tax rate)?
    Example: 50K Ordinary Income, 25K depreciation recapture, 125K in capital gains, and 75K in deductions and exemptions. I believe the deductions & exemptions reduce the taxes owed on the highest tax rate first (ordinary income and depreciation recapture? ) so then tax would only be owed on the capital gains (over the 75K exemption limit).

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