Today we’re going to talk about how to (legally) take the most advantage from your rental property. Tax law is something that many property owners don’t know much about but can provide a lot of additional return. Everyone has a different level of experience with the tax law and knowing what to expect and budget.
As a real estate investor, it’s important to know when you can just use some kind of automated software and when you need to hire an accountant with specific real estate knowledge. There is money at stake. Some people have enough knowledge to throw numbers in Turbo Tax and call it a day. The important point is that accountants who specialize in this are trained to cover their fee with savings. There are so many deductions and nuances in the tax code, it’s almost always going to be worth hiring a professional.
The first step is to have all of your facts and records in order. Know the facts about your property and how you spent your money. That step is relevant whether you hire someone or do it yourself. And once you have the facts before you, there are plenty of moves to make to increase your bottom line with tax loopholes.
What a CPA Can Help With
The right accountant can help property investors with a lot more than yearly tax docs or submissions. A knowledgeable professional can assist with things like tax planning, forecasting as well as non-tax considerations like updating wills, changing insurance and the legal aspects of owning an LLC or partnerships. The losses in these areas can be a huge hassle down the road. It’s important to partner with someone who thinks dynamically and can help you create a long-term plan.
Depreciation on an Investment Property
Income and expenses aren’t as straightforward as you might think. There are, of course, expenses like paying a property management company or repairs. It’s important to also keep depreciation in mind. The tax code provides for up-front deductions on the expenses you pay out to improve a home in some circumstances.
Depreciation is available for capital assets, like investment properties/real estate holdings and the items within them. Equipment, fences, appliances, etc. are different classes of assets with differently defined depreciable lives. These may have five year or fifteen year lives. Categorizing expenses is important for the complex rules for those assets. Fixing versus replacing certain items is a decision that could be impacted by the tax consequence.
Starting in 2022, the amount you can deduct will change. Bonus depreciation can accelerate some of the deductions.
By way of example:
Chris bought a new property and spent about $30k in improvements. Out of that, $25k falls into the category of bonus depreciation (fridge, furniture, fixtures, etc.). In the current code, he can take 100% federal depreciation on that, meaning it can all be written off in the first year.
Some states don’t conform to this, so there may be adjustments at the state level but the federal is usually higher, so it’s a benefit most of the time.
If Chris writes off $5k in expenses and were in a 20% federal tax bracket, he would have paid $1k less in taxes.
However, with this depreciation, he can write off $25k. This could mean $5k back in his pocket after taxes.
There are numerous “what-ifs” in this scenario, but the illustration is sufficient to prove the value of knowing these guidelines and just how beneficial they can be.
The government has this infrastructure in place to incentivize investment.
Cost Segregation
Many property owners think it only makes sense to do this on commercial properties, but highly skilled CPAs can do cost segregation on any kind of investment property. For laymen, cost segregation is a way of breaking out individual items into shorter life assets, which provides more depreciation in the near term. It’s less common on residential properties but is possible and may provide benefits, especially in specialized circumstances.
Timing Property Investments
There are plenty of timing considerations that can enhance your income on a property. For instance, projecting out several years and anticipating tax brackets or new legislation may help you make better timed decisions about depreciation bonuses.
An example of this timing is when to buy and when to sell a property. In fact, if you time it right, you may be able to avoid some major taxes when you sell an old property and buy a new one. If you reinvest the proceeds of your property into another property, you can avoid the tax payment. This does require a qualified intermediary and there are time restrictions.
Real estate is a broad category with some flexibility. Doing a 1031 exchange, also referred to as a Starker exchange or like-kind exchange, can enable investors to indefinitely defer the capital gains tax, even when selling or buying properties. Currently, this model could be built for a legacy and is a powerful tool. Much of this will depend on proposed legislative changes and the rules are always changing. Having good tax counsel is important.
Investment Property Expenses and Write-Offs
Regular expenses related to an investment property, that can most likely be written off on taxes, include:
Insurance
Property management fees
CPA fees
Interest
Taxes
Mileage (to and from property strictly for business purposes)
When determining if something is used for personal or business reasons, “primary” is the keyword. If you’re doing something primarily for business purposes, it’s more likely to be a legitimate expense that can be written off.
For write-offs like mileage, contemporaneous documentation is important. You need accurate (and may need detailed) records for the trips you take to oversee investment properties.
Active v. Non-Active (or Passive) Real Estate
Rental real estate is inherently passive in the tax code. Passive losses cannot offset active income. If you have losses from your rental property, you can’t take those net passive losses to offset income. They get suspended and go forward until you have passive income or you’re selling the property.
Passive income is subject to the net investment income tax. If you can, you want to be non-passive or active. If you’re a real estate professional, you can shift the situation to being non-passive. This applies if you’re working 750 hours in the real estate profession, spend a certain percentage of time in real estate, etc.
For investment property owners who have a different day job, they’ll more than likely have passive income. There are complex rules and it’s based on year to year data. Every year stands alone. The more a property owner is physically doing, the more likely they are to rise to the standard of non-passive income or loss.
If a property owner is just getting mailbox income, they may not be able to access those losses. But if you’re out there fixing the roof, collecting the rent or mowing the lawn, you can probably get to the right level of engagement. This circles back to the importance of tracking time and details. If you claim that you are active, you need to be able to prove it (with contemporaneous, written documentation).
Vacation Homes
Vacation homes that you rent, or homes that are used for mixed-use for personal and business, are subject to complex tax rules. The days you count for business use don’t count toward personal use.
Converting a Home Into a Rental Property
There are some important things to think about if you are thinking about converting your home into a rental, or doing the opposite (moving back into a property that had been rented). If you sell your primary residence, there’s a capital gains tax exclusion for <$500k (married filing jointly). There are time restraints and some details that apply to that.
If you’re converting from a primary residence to a rental, to get the gain exclusion, you must have lived in that house for two out of the last five years. If you know you’re going to sell it soon but aren’t quite ready, you can move out and still have access to that gain exclusion. Once that five year period lapses, the exclusion goes away.
In regard to the basis for depreciation: once a property is converted to the rental, depreciation rates are either set at the value of the house or the cost of original purchase.
These rules have their own level of complexity. For instance, if you want to move a relative into a rental property, it needs to become the primary residence. It’s important to take care in any transition like this.
Accounting For Your Investment Property
Facts and circumstances change and some of these accounting practices are subject to the interpretation of law and ever-changing regulations and detailed guidance. The ultimate answer to most property management tax and finance questions is: “it depends.” Every situation is unique. Your best bet is to hire a qualified CPA who can walk you through your best options for filing taxes and general accounting.
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