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PostHeaderIcon Rental Real Estate Taxation Basics

While I continue to fret over my “about me” page, one of the things people ask me is, “What is your specialty?”  Over the course of my 18+ year career in tax, to a certain extent, I’ve done it all.  I’ve worked on billion dollar bank and insurance companies and large multinational manufacturing companies all the way to the businesses that bring their receipts in a shoe box.  Still, for most of the past ten years I’ve been immersed in real estate.  They’re not the only clients I work on but it’s become a niche I’ve embraced.  This includes big real estate (I spent over five years in the tax department of a publicly traded REIT) to local real estate working with investors mostly in the Detroit-metro area.  You’ll also find that a lot of the content on this site is real estate related.

One of the things I haven’t touched on in a post is the taxation basics of rental real estate.  If done right, rental real estate can be a great investment but when you take into consideration some of the favorable tax rules that surround it, it can definitely be something you want to look at to add to your portfolio of investments.

First off is the disclaimer. I’m going to making a lot of general statements but as always, everyone’s tax situation is unique so be sure to consult with a professional before you put any of this advice in place.

The first question I usually get asked is about entities.  I’m going to focus on just the tax implications and leave the entity protection discussion for your attorney.  If you want to buy and hold real estate, most of the time you’re going to hold it in a non-corporate entity.  If you want to read about why you probably don’t want to hold real estate in a corporation, I discussed that specific issue in a separate post.  Most of the time you’ll be dealing with a limited liability company (LLC).  If it’s a single member LLC, you’ll be reporting your rental real estate activity on Schedule E of your 1040.  If its a multi-member LLC, then the default tax form is the Partnership Return, which is Form 1065 with the specific rental activity being reported on Form 8825.

The next question I’m usually asked is “What can I deduct?”  The IRS’s general rule is an expense has to be ordinary and necessary expense in carrying on the  trade or business.    As usual they like to keep things vague but the first bucket of expenses are what I call the Big Three.  This is your interest, insurance and taxes.  Rental real estate will almost always have insurance and taxes and if there is leverage involved, you will have interest as well.  In dollar terms, those three expenses usually make up the bulk of you cash outflows.  If you hire a property manager, that is also a deductible expense.  Repairs (not to be confused with capital improvements) can also be deducted as can utilities if that’s a cost you incur on behalf of your tenants.  Costs to advertise the property are also deductible and you can also deduct your mileage if you’re making trips out to the property (within reason). You can also deduct legal and other professional fees (accounting and tax as an example) as well.

I mentioned repairs and you have to distinguish between a deductible repair and a capitalized capital improvement.  Lets use a roof as an example.  If you have someone come and patch up your roof, it’s probably something you can deduct. If you’re replacing the entire roof, that would probably fall more into the improvement category and you should capitalize it and depreciate it over its useful life.

Which leads me into depreciation.  When you buy a piece of real estate, you buy several different things.  You get a building, you get land and unless the house is gutted, you also get a lot of fixtures, pipes and wires.  You have a couple of choices when it comes to depreciating your property.  One option, although it’s usually not cost effective for single family homes, is a cost segregation study.  When you do a cost seg. study, you really break down the cost of what you’re buying and the end result is, you usually get property that you can depreciate over a shorter useful life (i.e. more depreciation expense now) versus property you can depreciate over a longer life (less depreciation expense now).  The other option is to just go with an estimate like an 80/20 split between property and land with the 80% being depreciated over 27.5 years.  You don’t get to take advantage of the quicker depreciation tables but you also have to spend less administrative time and money to break everything down.

When you prepare your taxes, the calculation isn’t that challenging but you have to make sure you fill out the form completely and accurately.  You take your rental income and subtract your cash expenses and your depreciation to come up with a net number.  If it’s a positive number, it’s either reported on your 1040 or it will flow through from your Form 1065 via a Schedule K-1.  If it’s a loss, then it gets a little trickier because the passive activity loss rules can get complicated.  I will save how and when you can take these losses for a post of its own.

Hopefully this is enough to get you started or if your already renting property, it validates what you’re doing. There are some other strategies I’d like to talk about, including ways to set things up if you own multiple properties, but this is getting a bit long and I will save those as well for a future piece.  As always, if you have questions, you can find a few different ways to contact me on my contact page or if you have a comment, feel free to leave one here.

PostHeaderIcon Real Estate Professional Status Tax Planning

Alright, over the last few weeks I’ve gone through the requirements you have to meet in order to deduct real estate losses as a real estate professional.  If you didn’t catch them, I did it in three parts and you can click through from here.

Real Estate Professional Rule 1
Real Estate Professional Rule 2
Real Estate Professional Rule 3

Now we’re going to talk about some planning ideas.  This is going to be a living post in that whenever I have a thought or learn something new on being a real estate professional, I’m going to add it here.  As always, I’m going to keep things general and you should always consult with your tax adviser before you implement any of these ideas.

1)  We’ve talked about how it can be tough meeting the 50% rule if you have a full time job.  That means if you work full time, you have to come up with at least 2,000 in your real estate business.  That doesn’t leave a lot of time for sleep.  One was to meet the requirements is if you have a spouse who’s either been out of work or is a stay at home parent.  If they’re not involved in the business and you find yourself not being able to take your losses because of the passive activity rules then it’s time to get them involved.  They still have to meet all three rules though.  One spouse can’t meet one rule and the other spouse two rules, in order to qualify one spouse has to meet all of the three rules.

Fortunately, while being a full time parent is as hard as any job, it doesn’t qualify as a business so most of the time, if the spouse can meet the 750 rules, then they’ll meet the other two rules as well.  So get your husband or wife involved and that can help you deduct those losses.

2)  Remember about the grouping election.  If you don’t elect to group your real estate activities, then you have to meet the active participation for each one individually which can get challenging as your real estate portfolio grows.

3)  Short term rentals don’t apply. If you have a vacation rental where the average lease term is seven days or less, then the hours devoted to that activity don’t qualify.

PostHeaderIcon Real Estate Professional – Rule 3

Alright, we’ve talked about what you need to do to qualify as a real estate professional for tax purposes.  Rule one was the 750 hour rule.  Rule two was the material participation rule.  The final rule that we’ll be talking about today is what I call the 50% rule and for a lot of people, it’s the one that trips up most people and disqualifies them from being a real estate professional.  How the 50% rule works is, you have to spend more then 50% of the time you spend on personal services for the year in real estate and rental real estate trade or business activities.

Where most people run into problems is when they have a full time job.  If you spend 2,000 hours at your job, you then have to spend 2,001 hours on real estate to qualify as a real estate professional.  That doesn’t leave people too much time to sleep.  And these people (those who get a W-2 and then claim to be a real estate professional) are some of the people the IRS is targeting.  So look at the 750 hour as the minimum but what you really need to get to is a match of time you put into your other businesses or jobs.

I’ll have one more post on the real estate professional status before I move on to something else.  It’ll be mostly some planning ideas.

PostHeaderIcon Real Estate Professional – Rule 2

A couple of weeks ago, I touched on qualifying as a real estate professional and I talked about the 750 hour test.  Rule two is that the 750 hour test has to apply to activities in which the person materially participates.  The catch here is you have to look at each activity individually (sort of, I’ll get to the exception in a minute).

In order to materially participate, you have to meet one of the following requirements:

1)  The taxpayer spends 500 hours on the property.
2)  The taxpayer does most of the work.
3)  The taxpayer works more then 100 hours and nobody else works more hours then he does (this is the one most people shoot for).
4)  The taxpayer has several activities and spend in which he spends 100-500 hours each and the total time spend is 500 hours.
5)  The taxpayer materially participated in an activity for five of the last ten years.

Where you run into the most problems is when you have multiple properties.  Fortunately the IRS lets you make an election to group all of your properties together as one activity.  You have to make a formal election on your tax return though and if you’ve never done this and have put yourself out as a real estate professional, you do have some risk.  The election isn’t all that complicated, but if you’d like a free template, feel free to send me an email or a Facebook message.

PostHeaderIcon Real Estate Professional – Rule 1

Real estate can be a great way to both build wealth and shield the money you make from your investment from taxes.  Of course the down side is, if you have a tax loss from your real estate investment, you can’t always use those losses especially against income you may receive from your job.  You’re even further limited the more money you make and while the passive activity rules are complicated enough and a discussion for another time, one way to ensure your losses are utilized as quickly as possible is to qualify as a real estate professional.  By qualifying as a real estate professional, you can usually take your losses in full and in the year you incur them.  It’s not always easy to qualify, but there’s three rules that have to be met.  As always, this is general information so be sure to talk to your tax adviser so he can opine on your particular situation.  We’ll cover the first one here today and the other two in subsequent columns.

The first rule is that you have to spend 750 hours to rental property activities.  I know I lead up to this and it’s one of the easier rules to understand, but you also have to be careful because in order to qualify as a rental activity, the average rent term has to be longer then a week.  If it’s shorter, then the time doesn’t count.   So if you have a short term rental property like a vacation home where you rent it out for six days and have a cleaning day, then you can’t count your time related to that activity.

Keep your eyes open for rule number two in the next couple of days.