New and potential real estate investors, unfortunately, often fall into one or more serious tax traps.
Accordingly, the discussion that follows identifies these traps, or mistakes, and then ways to side-step the trouble.
Some of the material covered in the paragraphs that follow is a little, er, tedious. But keep in mind as you plod through some of this stuff that what you want to do is avoid mistakes that cost you thousands of dollars a year in lost tax savings.
And with that, you’re ready to get started.
Real Estate Tax Trap 1: Passive Loss Limitation
The first tax trap you want to watch out for is the passive loss limitation.
You may already know this, but to the taxman (and even your accountant), real estate doesn’t look like a money maker. No way.
And there’s a pretty simple reason for this: Depreciation.
If you own a rental property that makes enough money to pay the operating expenses and the mortgage, the tax accounting still shows that property as a money loser because a chunk of the purchase price gets written off each year on your tax return.
Suppose, for example, that you have a property that generates $15,000 a year of net operating income and that you use this cash flow to pay the mortgage (which we’ll also say is $15,000).
Logically, this is a breakeven deal for you, right? And if the property is increasing in value by, say, 3% or 4% a year, you are probably enjoying pretty darn good investment returns. The tenants are paying off the mortgage on an asset that’s steadily growing in value and which at some point you’ll own free and clear. Sweet.
If you’ve done any research on how the taxes with this stuff works, you also know the situation gets even better. Even though you’re breaking even on your cash flows and making money from the appreciation, you can depreciate, or “write-off,” the purchase price as a tax deduction on your tax return.
You can for example depreciate a residential property over 27.5 years. And you can depreciate a commercial property over 39 years. Accordingly, a rental house that cost $275,000 or a commercial building that cost $390,000 would both generate $10,000 a year in depreciation write-offs each year.
This depreciation write-off saves you taxes. If your last $10,000 of income (say from a job) is taxed at a 30% marginal federal and state income tax rate, you save roughly $3,000 in federal and state income taxes through the depreciation write off.
Note: Only the building and its components get depreciated. The land doesn’t get depreciated. So the $275,000 house referenced in the previous paragraph may have really cost you $350,000 once you also include the $75,000 of land the house sits on. And the $390,000 commercial building may have really cost you $490,000 once you include the $100,000 of land the building sits on.
Real estate investors know about this deduction of course. The tax write-offs from depreciation become another component of the allure and attraction of real estate.
But there’s a catch-and this is where the trap is. Congress has partially closed this loophole through something called the passive loss limitation rule. In a nutshell, the passive loss limitation says you can’t use “fake” or “paper” depreciation-type losses on real estate investments to reduce the taxes you pay on non-real-estate-related income.
In other words, you can’t use real estate generated passive losses to reduce the taxes you pay on your wages or on interest, dividend and capital gain income.
So that’s the bad news. But there’s also a bit of good news for some real estate investors.
First of all, active real estate investors with adjusted gross incomes less than $100,000 may include passive real estate losses of up to $25,000 on a tax return. And note that if your income is more than $100,000 but less than $150,000, you get to use a pro rata portion of the $25,000 “active real estate participant” allowance. If your income is half way between $100,000 and $150,000, for example, you get half of the $25,000.
The upshot of the active real estate participant rule? If your income level means you can use the depreciation write-offs, make sure that you participate enough in your real estate investment to qualify as an active investor. (Essentially all you’ve got to do is provide some basic supervision such as picking a property manager and approving tenants.)
By the way, a second trick will allow other real investors to avoid the passive loss limitation. If you’re someone who spends at least 750 hours a year and more than 50% of your work time on real estate, you can probably qualify as what tax law calls a “real estate professional.” This is important because the passive loss limitation doesn’t apply to real estate professionals.
Just to make this point, a real estate professional according to tax law is not someone who’s passed a test or received a license or some other credential from the state. The real estate professional designation gets made based on the hours a person spends on real estate and the percentage of their work life devoted to real estate.
The upshot of this “real estate professional” stuff? If you can, qualify by keeping a good calendar or log of your real estate hours.
And one final, really important caution about qualifying as a real estate professional: Investors may need to aggregate several real estate investment properties into one catchall “job” in order to meet the hours and percentage tests. If you own three small apartments, for example, and each requires 400 hours a year of your time, you won’t qualify as a real estate professional unless you make a special election to combine all three properties into a single, 1,200 hours a year property management job. (If you have questions about this, ask your tax advisor for more information. And if you don’t currently have a tax advisor who really understands real estate taxation, consider using our firm for this help.)
Real Estate Tax Trap 2: Capitalization of Improvements
One absolutely must talk about another common real estate tax trap, too, that’s sort of related to the passive loss limitation stuff.
When you spend money maintaining or repairing a property, you potentially create another deduction. And that’s good in a sense because you’re maintaining or increasing the value of your asset and getting a tax deduction, too.
But there’s a potential problem with some repairs and maintenance expenditures. Repairs and maintenance expenditures can be deducted on a tax return in the year you spend the money. But money spent to improve a property needs to be depreciated over 27.5 years if the property is residential or over 39 years if the property is nonresidential.
How does one distinguish between repairs or maintenance expenses versus expenditures for improvements that should then be depreciated? It’s sometimes tricky. But the general rule is you have to depreciate if the expenditure extends the life of the property or improves its utility.
Painting the inside or outside of the house, maintaining the landscaping, fixing a hole in the roof or a broken window should all be repairs and should be immediately deductible.
Putting in new landscaping (which probably lets you increase the rents), replacing the roof, replacing old windows with new energy efficient windows (which all extend the property life) should all be capital improvements and then be deducted over 27.5 or 39 years.
You can’t always avoid the repairs vs. capital improvements trap. But you do have a tactic you can use to minimize the expenditures you have to depreciate. You don’t want to defer maintenance. Rather, keep your property in tip-top shape from the get go.
The reason for this is that if you let all sorts of deferred maintenance build up (over, say, the course of several years) you end up in a situation where the stuff you’re doing now constitutes improvement to the property and not simply maintenance of a continuing condition.
Real Estate Tax Trap 3: Missing the Section 121 Exclusion
Finally, one cannot forget about a final tax trap. And this last tax trap is probably the saddest mistake a tax accountant sees.
Sometimes people decide to keep their principal residence as a rental when moving to a new location or moving into a new house.
This “Gee I guess I’ll become a landlord” decision is maybe okay if you absolutely can’t sell the old place. And the decision doesn’t turn into a tax disaster if your home has declined in value since you purchased. But if your “old” principal residence has increased in value, this decision may cost you tens of thousands of dollars in tax.
Here’s why the accidental landlord decision becomes expensive: One of the best loopholes in the Internal Revenue Code is Section 121. It says that if you have owned and lived in a residence for at least two of the last years, you won’t pay any tax on the first $250,000 of gain on the sale if you’re single and on the first $500,000 of gain if you’re married and filing a joint tax return.
In other words, tax law lets you make up to a quarter or even half a million dollars of profit—tax free—as long as you meet the “two of last five years” rule.
By converting an appreciated principal residence to a rental property, then, you turn tax-free gain into taxable gain if you don’t sell the property in the first three years.
What you usually want to do, accordingly, is sell a principal residence if you can enjoy the Sec. 121 exclusion. And if you do want to reinvest those proceeds in rental property, no problem, use the proceeds to acquire some other property.
Free Excel Templates and LLC Formation Kits
You’re on this page to get general real estate investment information. We get that. But can we point out that we have some free nifty giveaways for real estate investors? You might be interested in grabbing one or more of these items…
If you’re flipping real estate properties—and you’re making money—you probably ought to consider operating as an S corporation. And in this case, you may want one of our free S corporation do-it-yourself kits. (We have kits for all fifty states.) Click here to get to the page that lets you identify the state you need a kit for and then lets you grab the free kit.
Note: If you’re not flipping properties but are instead holding property for longer term investment, you don’t want to use an S corporation. But you may want to use a limited liability company. Accordingly, note that we also giveaway free do-it-yourself LLC formation kits for all fifty states from our www.llcsexplained.com website. The free LLC kits come with forms and boilerplate operating agreements for your state.
Finally, we’ve also got a series of free Microsoft Excel templates available for download—and many of these are specifically designed for real estate investors.
Mortgage amortization templates:
- 15-year fixed rate mortgage amortization schedule
- 15-year adjustable rate mortgage amortization schedule
- 30-year fixed rate mortgage amortization schedule
- 30-year adjustable rate mortgage amortization schedule
Rental Property Analysis templates:
- 10-year cash flow forecasting template (does NPV and IRR calculations)
- Multifamily property real estate investment analysis template
- Home affordability calculator template
To download a template, right-click the hyperlink and choose the Save Target As command.
One other tip related to the multifamily property analysis template referenced in the preceding list. The Analyzing Multifamily Real Estate Investments web page at this website describes in more detail steps you take to use that Excel template.