We’re going to talk about legal ways you don’t have to pay taxes… and that should excite just about anybody!
Here’s the reality: the IRS wants you to invest in real estate.
We’ve talked before about how your investment property is a briefcase full of money. Your goal is to grow it as fast as possible. Good accounting tells you where and how to keep your money.
What Does a Property Manager Account For?
There are a few pretty obvious, straightforward things that are part of property management accounting.
Rent: collect, account for, distribute proceeds appropriately.
Fees: charge, collect, record.
Repairs/expenses. These are not all categorized the same by the IRS, so be sure to record the exact nature of the repair or expense (capital improvements versus regular maintenance, cleaning and maintenance versus supplies, etc.).
Other income and deposits. This is important for compliance (placing it in a trust account, keeping records, etc.).
If you ever go to court, your ledger must be up-to-date and accurate. Anyone can collect rent without good records, but it’s an essential practice to have a month-by-month record. This should breakdown all property expenses and anything you collect.
Tax Software vs. CPAs
In our experience, tax software is often insufficient to record the kind of detail you need for maximizing your investment property after-tax return. There is a vast quantity of claims you can make. Remember that CPAs went to four + years of college, studied for many hours and have a ton of experience, all of which can save you a lot of money. Every situation is nuanced and it’s too complicated to just leave it to software. A good CPA will catch plenty of things that software will miss.
Remember, there are all sorts of CPAs. Go to one who really knows what they’re doing and has experience in this. If you have a real estate portfolio, go to the right professional.
When you go to a CPA at the end of the year, be sure you have all of your docs in order. These will include invoices of repairs and expenses, your updated ledger with all financial records and any other documentation. Obviously, it’s ideal to stay on top of all expenses and income through the year so that you have a single, detailed report at the end of the year.
Issuing Owner and Vendor 1099s
A property management company will always send owners a 1099 at the end of the year. Some companies will charge an extra fee for sending these, which is interesting because they are required to do it.
If you are managing a property on your own (without a company), you need to be aware of the fact that you are required to create and send 1099s for vendors under certain circumstances. Most of the time, a management company will do this for you.
Property Owner Accounting Requirements
Even if you have a property management company doing a lot of the work for you, there are a few things you are still responsible for:
Annual property taxes
Mortgage payments (keep track of interest v. principal v. escrow payments)
Insurance (landlord, which is deductible)
HOA fees
Depreciation
On Schedule E, you’ll have to itemize expenses, which means that you can catalogue deductions.
Property management fees are also deductible, which is a way to offset that management cost.
A Word About Depreciation
Compared to other asset classes, real estate has distinct advantages:
Cash flow
Appreciation
Depreciation
Leverage
These are the four main ways you can make money in real estate. In theory, most real estate goes up in value, but you can tell the federal or state government that the property is in fact going down in value. And, it is. Separating the value of the building and land, you can depreciate aspects of the building (in different ways). You can write off a portion of what you paid for the building every year, telling the government that is an expense. This is powerful because you didn’t really incur the expense, at least not yet.
It’s very typical, in real estate investing, to make cash flow but have a loss on paper. It’s legal to do this. In fact, the government wants you to do this. Most of the code book tells you how to avoid paying taxes. Depreciation on real estate is one of the ways to do that.
How Accounting is Sexy
Chris bought a property this year and put a lot of money into rehabbing the property. Right now, with the JOBS act, a lot of things can be expensed out in the same year. He had a loan for the purchase price but then got financing above and beyond that for covering repairs (about $30k). With those financed repairs, there was no money out of his pocket for the $30k. His accountant is doing a cost segregation analysis, which is kind rare, but breaks out the components of your property to expense and then deduct.
Because of this, he can write off $50k-$60k this year. Depending on your income threshold and how involved you are in real estate, you may or may not be able to write off at this level. Long story short, it’s still your write off that you can keep and carry forward. Because he is an active real estate professional, he can offset that against his income. If you were in a 25% tax bracket, that could be a +/- $15k benefit in the first year!
Some people are hesitant to rent their properties because the rent will be less than the mortgage and they’ll see it as a loss. There could always be some kind of tax write off that actually makes you money, without that monthly equation in play. That’s where this starts tipping in your direction.
A property investment isn’t just about how much money goes in your pocket each month; you have to look at the big picture.
Final Words: Making Money on Your Property
Remember that the tax code is full of benefits for real estate investors. You have to use these responsibly and consult with a tax advisor, but there is plenty of money to be made. When you pull back and look beyond month-to-month income, you can build real wealth.
Anytime you sell an appreciated asset, the government considers it income. The government always wants to tax you on your income. There is tax law (Section 1031 of the Internal Revenue Code) that allows for a very specific process to indefinitely defer taxes on gains when you sell a property. This is also known as a 1031 Exchange or Starker Exchange.
If you take a loan out on a $200k property and pay $40k in cash. After 30 years, you not only have a $200k property (which has probably grown to be close to $500k in value). You’ve not only made income as you’ve had the property, but you also have an extra $460k that you don’t have to pay taxes on if you take advantage of this tax loophole.
Buy and hold real estate is the source of massive wealth. Almost anyone who has amassed significant wealth in this country has this as part of their portfolio. If you persevere, you have enormous potential to make legacy wealth.
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Disclaimer: we are geeks, not accountants. In this episode of the Investment Property Geeks of Charlotte, we offer illustrations and our considerable experience but it should not replace the official advice of a professional accountant.
