Brian Borawski CPA, PC

Archive for the ‘Tax Planning for Real Estate Investors’ Category

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.

Selling an asset can be taxing and sometime you run into problems when you sell an asset and you don’t collect all of the money at once.  Let’s look at an extreme example.  You have a building that’s worth $1 million but you’ve owned it for so long that it’s fully depreciated so if you sell if for $1 million, you’re going to have quite the gain.  Since it’s a long term capital asset and you sell it by the end of this year, your gain would be 15%, or $150,000.  You had a hard time finding a buyer and the one you finally found is cash strapped and they put 10% down and you seller-finance the rest.  The problem here is, your tax ($150,000) is actually more then the cash you received ($100,000) so you’re left with a shortfall.

That’s where the installment sale rules come in.  You can elect to report your gain on an installment basis if you expect payments in a tax year after the year of sale.  This is done on Form 6252 and the first thing you need to do is compute the gross profit percentage. In our example, since there’s no longer any depreciable basis, the gross profit percentage is easy because it’s 100%.  That means whenever you collect principal payments, you pay tax on 100% of the amount received.  In our example, the down payment would result in a $100,000 or $15,000 in tax (assuming this year).  If you collected $50,000 in principal next year, that would be your gain in that year and so on until the note is paid off.

One interesting quirk this year is capital gains are expected to go up in 2013 so you might want to actually pay the tax on the entire amount rather than wait and potentially pay a higher tax rate in the future.  The good news is, you elect the installment method when you file your return so you could potentially put off the decision until you have a better handle on what tax rates will be.

Many people feel that the two absolutes in life are death and taxes.  In my experience, if there’s something that comes to close to a third absolute it’s that you should never hold real estate within a structure that’s taxed as a corporation.  I can give you some examples of where it works out okay but still not as well as under a structure taxed as a partnership but I can give you a few different examples of where you can have some disastrous tax circumstances when holding real estate in a corporation.  The primary pair of reasons are basis rules and distribution rules.  As always, I’m keeping this simple so if you have a specific situation that applies to you, be sure to contact a professional.

Let’s say you get a great deal on a property.  You’re able to buy a $1 million piece of property for $500,000 and because of the great purchase price, you’re able to finance the entire $500,000 with  a bank loan.  Let’s take a look at what happens in two years when you try to distribute this piece of property out of your legal entity.

If you bought the property under an LLC that’s taxed as a partnership, you’d be in pretty good shape.  You’d probably (it would depend on the bank note) be able to pass through any losses from the partnership because your debt has given you basis.  In two years, if you distribute the property out of the LLC, it’s a tax free transaction and the property would come through with its basis and carrying period intact.

If you bought the property under a C-Corporation, you’d have a mess.  When you distribute property, it’s the same as if you sold it then distributed the proceeds so you’d have about a $500,000 gain that the C-Corporation would have to pay (plus any depreciation that you took in those two years).  On top of that, the distribution would be taxable to the shareholder at the value of the property or in this case, $1,000,000.  Those two layers of tax that will chew into that $500,000 in savings you picked up when you bought the property pretty quickly.

While not as bad as the C-Corporation example, if you had put it under a corporation that had made a Subchapter S election, you’d still have some tax to pay.  You wouldn’t have any basis in the corporation because the debt from the bank note isn’t eligible as basis.  You’d have the capital gains hit that would occur at the S-Corporation level (which would ultimately flow through to the owner’s personal return) but not the second layer of tax because the dividend would come through half tax free and half as a taxable S-Corp distribution because you’ve established some basis when the capital gain was taxed but not enough to cover the entire $1 million.

In short, putting into an LLC is pretty much a no lose situation.  Putting into a corporate structure, you could have a tax mess on your hands.  Be sure to discuss your personal situation with you tax adviser.

Yesterday I gave the ins and outs of cost segregation studies.  Today, I’m giving you some of the research resources attached to it.  One good place to start, if you don’t mind the investment is CCH’s U.S. Master Depreciation Guide (2011). This guide book will give you the ins and outs of the depreciation rules like nothing else will and it comes with CCH’s top notch explanations.

If you don’t want to spend the money, then I’d recommend Publication 535 which has a section on capitalizing assets in it.  I’d also highly recommend the Audit Technique Guide on Cost Segregation. Between those two things, you should have the tools to at least get started.

Whether you call them quickturns or flips, real estate investors who primarily rehab a property and then sell those properties rather quickly may fall into a trap.  If the IRS considers you a “dealer” then they basically consider you to be no different then a retailer.  Your houses are you inventory and the sales are your proceeds and more importantly, the gross margin is subject to self employment tax.

One easy way to get out some of the self-employment tax is to incorporate.  Whether it’s an S-Corporation or a C-Corporation, there is no self employment tax.  Of course then you have the complications that surround corporations including payroll and corporate entity maintenance.

There are some other factors the IRS may look at to determine whether you’re a dealer or not.  Here’s a good piece on some of the things the IRS considers.

I was recently on the Just Start Real Estate podcast sharing tax and business tips for new and prospective real estate investors.  You can check out the show notes here and you can download the podcast here. It was a lot of fun and if you have further questions (or you’re making your way here after listening to the podcast), feel free to leave a comment here.

Let’s start with a case study to set this up.  You live in the Detroit area so let’s assume a major sporting event is coming back to town like the U.S. Open and they’re holding it at Oakland Hills.  You’re lucky enough to own a home less than a mile away from the golf course and an international financier agrees to rent your house for an obscene amount of money to live in your house for the week.  You move into a local hotel and a week later, you move back into your house.  Tax time rolls around and now you’re worrying about how to report this on your taxes.

Fortunately, the answer is, you don’t have to do anything.  If you rent your home (or your vacation home) for less then 15 days, you don’t have to report it all.  There is no income limit so if someone was stupid enough to pay your$100,000 to rent your house for a week, you wouldn’t have to show it anywhere on your tax return.  The safe harbor period is two weeks. As long as you rent your home less than 15 days, then no reporting is required.

Things get a trickier if you rent your house for a longer period of time.  Then it’s a big proration exercise.  So if you spend $2,400 on property taxes that’s $200 a month and if you rent your house for the four winter months, then $800 would be reported as a rental expense and the rest would show up on Schedule A if you itemize.  This also creates some extra reporting when you sell your house because if you qualify for the principal residence exclusion, you’ll have to recapture and pay tax on any depreciation you took while renting out the house.

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.

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.

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.