It’s tax time of the year. As a new real estate investor and long-time DIY taxpayer, I’m always looking to systematically educate myself about various tax benefits I can use. I stumbled upon this book on BiggerPocket: “The Book on Tax Strategies for the Savvy Real Estate Investor”. It has a good review on Amazon so I decided to give it a try. It’s an easy read so I summarized take-aways in this post for future references.
For W-2 employees, deductions are rare since the Tax Cuts and Jobs Act of 2017. Not much we can do about reducing taxable income.
However, real estate investing is treated as “business”, whether or not the title of the properties are held in personal names or in legal entities. Having a legal entity is not an IRS requirement to write off real estate or business expenses. On the contrary, the IRS simply requires that you have a “business”, defined as “activities with the goal of making profit.”
It allows to deduct “business expenses” against income, whereas personal expenses are generally not deductible. The main thing the average taxpayer needs to understand is the definition of “business expenses”. The IRS has only two criteria:
- The expense must be ordinary in the course of your business. In other words, is this an expense that occurs commonly in your business?
- The expense must be necessary in the course of your business. In other words, this is an expense that you must incur to crate profit as a real estate investor.
Property taxes, mortgage interest, management fees, home owner association fees, and repair and maintenance are well-known write-offs. But there are many more: marketing for new tenants, office supply, car and travel deductions.
We should make it a habit to track deductible expenses, car trips, and keep receipts. We are in control of the tax bill and tax advisors maximize our tax savings based on the information we provide.
You can deduct travels too if you plan properly. For you to deduct 100% of your travel expenses, such as airfare, hotels, and taxis, you must be able to show the primary purpose of your trip was for business. The term “primary” simply means that more than 50% of your time is spent on business activities. Travel days, the days where flights are on, are considered as business days by the IRS and thus tax deductible.
The “week-sandwich strategy”: if you have business to do on both Friday and Monday, the weekend in between becomes eligible for tax deduction. So the following trip is fully deductible: fly in on Thursday, do business on Friday, leisure on Saturday and Sunday, do business on Monday, and fly out on Tuesday.
One of the main things to protect yourself from an audit is to have the right kinds of documentation in place. With regards to travel costs, the primary thing the IRS looks for is “business purpose”. The best way to prove your business purpose is to show that you had predetermined business activities, meetings, or events set up. These things must therefore be arranged before you leave on trip. The key to maximizing your tax deductions is to document your business activities for the trip.
If you want first class tickets for flights, deduct the price of economy class and pay the difference for first class out of your personal account.
Meals write-offs are 50% deduction. The tax code states that receipts must be kept for any entertainment expense over $75.
Owning properties in locations with family, friends, or favorite vacation is a good idea. Trips to visit properties or see new ones can be doubled as trip to family/friends, especially using the weekend-sandwich strategy.
Hire kids as employees can shift income from parents’ high bracket into kids’ low bracket by claiming them as business expenses. First, identify the reasonable compensation, i.e., “market rate” or “what would you pay someone else to do the task in question”. The payment should come out of business account as payroll and W-2 should be generated. Time sheet should be used to track work hours.
Kids earning income can have a Roth IRA opened. Roth IRA can allow money to grow tax-free and withdraw at a later time if needed.
Average home office creates write-offs between $2,000 and $3,000.
- The space must be the primary place of business.
- The part of your home that you use as your home office must be used exclusively for business purposes. Pictures can help to prove the legitimacy of home office.
The simplified method allows you to deduct $5 for each square foot of home office space, as a substitute of actual expenses. However, simplified method cannot generate loss.
Pass-Through Tax Deduction
In the pass-through tax deduction, the first 20 percent of certain types of income may be completely tax free. It has nothing to do with legal entities so you can still claim this deduction if the property is under your personal name. It is available for rental income when it is considered a “trade or business”. The “trade or business” requirement a difficult one to define, the IRS provided a safe-harbor test to help you determine whether your rental income is eligible for this pass-through tax break. Chances are high if you meet all four:
- You need to have separate books and records for your rental real estate activities.
- There needs to be over 250 hours of rental service activities done for the year.
- You must be able to produce records and documents to prove these hours and services actually occurred.
- You need to attach a signed statement to the tax return to indicate the safe harbor requirement has been met.
Establish business accounts for legal entities and use them to pay for business expenses. Business accounts cannot be used to pay for personal expenses. If business expenses are paid with personal accounts, reimburse yourself from the business account and keep receipts.
Assets must be owned by legal entities in order to get asset protection. Income, such as rents, must flow through the business entities.
Note, legal entities does not automatically mean tax deductions; on the other hand, lack of legal entities does not forbid tax deductions.
Legal entities incur costs to establish and maintain, so there is no one-size-fits-all solution.
Self-Directed Retirement Accounts
Self-directed retirement accounts are the same as as regular retirement accounts. The key difference is self-directed accounts let you choose what you want to invest in, instead of those available on the stock market. Thus, self-directed accounts can be used for real estate. IRS specifies certain things you cannot invest in retirement accounts, such as life insurance contracts and collectible items.
However, be careful when using leverage in retirement accounts. A tax called the Unrelated Debt-Financed Income (UDFI) tax is applied on any taxable income generated as a result of the debt. Solo 401(k) is not subject to UDFI tax, and provides the ability to borrow money from it (like regular 401(k) provides).
Some important things about depreciation of rental real estate:
- Depreciation is taken each year that the property is actively in service as a rental.
- The same depreciation is taken whether the property value increases or decreases during the year.
- Depreciation is generally taken based on the purchase price of the property, regardless its current fair market value.
- Depreciation is calculated based on your total purchase price of the investment property, regardless of what your down payment is.
Thus, leverage increases the amount of depreciation for a given down payment. Depreciation can be taken by the owner of the property.
Land is not depreciable; certain items in the building can be depreciated faster than the building.
Depreciation reduces the cost basis of the property when the property is sold.
Depreciation is not a choice. A depreciation deduction is required under the tax law.
Because different parts of the building has different depreciation lives, a cost segregation study separates out the cost of faster-depreciated items for accelerated depreciation. Accelerated depreciation gets you the same amount of total depreciation expense over the entire life of the building, but you get deduction of some of the items a lot sooner. Cost segregation study can be done any time, not just the first year when the property is put in service.
As part of the tax law change, 100 percent bonus depreciation is introduced. You can immediately write off certain assets in the first year instead of depreciating them over multiple years. Section 179 is also expanded. It is an immediate expense deduction that business owners can take for purchases of depreciable business equipment instead of capitalizing and depreciating the asset over a period of time. The Section 179 deduction can be taken if the piece of equipment is purchased or financed and the full amount of the purchase price is eligible for the deduction.
Deposition of Properties
“Dying while owning” is actually an advanced strategy commonly used by investors. The beneficiaries would get the step-up basis of fair-market value and wipe out all the unrealized capital gains accumulated through appreciation and depreciation.
Cancellation of Debt Income is the difference between the loan amount and the short sale price, a hypothetical income from the outstanding loan forgiven. Getting 1099 for cancellation of debt income doesn’t mean paying taxes; loss on the property can be used to offset it.
The gain and losses from real estate is treated differently. When you sell a property for a gain, it is indeed a capital gain, and you pay the long-term capital gain rates. However, when you sell a rental property at loss, the loss is actually considered an ordinary loss. An ordinary loss is better than a capital loss because
- There is no annual limit on how much can be used to offset your income, versus $3,000 from capital loss.
- You can use ordinary loss to offset your ordinary income, which is generally taxed at a higher rate.
Capital gains from the sale of property can be deferred in an 1031 exchange.
Guilty Until Proven Innocent
The taxpayer is guilty until proven innocent. Taxpayers are required to prove the tax return is correct in the time of audit. There is no such thing as being 100% audit proof. When you can do, however, is protect yourself with the 3-Layer Audit Protection Plan.
- Minimize audit risk. The best way to resolve an IRS audit is to never get selected in the first place.
- If you have an active real estate business with a lot of losses, it may make sense to operate as a legal entity.
- IRS identifies out-of-the-ordinary returns with numbers outside national and industrial averages.
- Accuracy and Matching.
- One way to guarantee that you receive an IRS notice is to have incorrect calculations in your tax returns, because this is something the IRS computer will catch automatically.
- Make sure your tax return amounts match what IRS has on its end, based on various forms filed by other parties, such as W-2 and 1099s. Do not skip anything even they are not taxable.
- Be specific about expenses. Break the expenses out into the correct categories. It is okay to have “other” or “miscellaneous” but keep them small.
- Documentation Support.
- Separate bank accounts for business and personal.
- Keep all receipts. In the event of an audit, receipts are our insurance policy. Digital copies of receipts are acceptable. Keep notes about the business purpose of the expense (e.g., write down whom you met with and what you discussed in a business meal).
- Other documentations such as before-after pictures of rehab, activity logs for business travel.
- Having representation still requires you to provide all the documentation.