Income Tax Planning for Real Estate Investments
Real estate can be a great tax shelter. There are quite a few tax laws that apply to real estate. This presents an abundance of tax planning opportunities.
The tax law in this area is constantly changing. This makes it difficult to keep up to date with the latest developments. What worked to save taxes a few years ago may not work today. This page provides an overview or framework for these tax laws.
Real Estate Tax Reporting
The tax rules for real estate vary based on the taxpayer who owns the real estate. This may include individuals who are single or married filing jointly, as well as what type of entity owns the property, be it an LLC, partnership, trust, or corporation.
Schedule E / Schedule C for Rental Properties
Real estate owners report their income and expenses for their properties to the IRS and state tax authorities each year. This tells the IRS and state tax authorities how much rental income was generated and what gains or losses from the sale or disposition of real estate were realized.
As we’ll describe below, landlords are able to deduct ordinary and necessary expenses incurred in rental activities. Those who hold real estate for appreciation or who hold property to fix and flip the property can deduct carrying costs for their real property.
The total amount of this income after these deductions is referred to as net real estate income. This net real estate income is what is used to determine the owner’s income taxes each year.
These amounts are typically reported on Schedule E, Supplemental Income and Loss. This form is filed with the real estate owner’s personal income tax returns. This schedule is used by real estate investors. Real estate investors are different than those whose real estate counts as a trade or business. Investors are more hands-off and less involved in their real estate.
Real estate owners who are able to treat their properties as trades or businesses report the net income and expenses on Schedule C, Profit & Loss From Business. These owners usually have more properties and spend more time managing their real estate investors who report their net income on Schedule E.
The distinction between an investor and a business owner can have a number of impacts on the owner’s income taxes, including whether the property triggers self-employment taxes and whether the Form 1099-S has to be filed when there is a sale. This can impact whether losses are immediately allowable, whether the real estate triggers capital gains or losses, and how large current-year depreciation deductions are.
Real Estate Business Entities
Some real estate owners choose to hold their real estate in legal entities. This is often done to protect against liability for the real estate and to shield the real estate from the owner’s own financial risks. It may also be required by lenders who advance money to purchase or improve real estate.
Real estate owners typically use a limited liability company (“LLC”) to hold title to their real estate. For tax purposes, the LLC may report the rental income and expenses on Schedule C or Schedule E as described above.
Alternatively, the owner may elect to have the LLC taxed as a partnership, S corporation, or C corporation. These entities file their own income tax returns to report the rental income and expenses on these separate income tax returns. These amounts reported on tax returns for partnership and S corporations then flow through and are subject to tax on the owner’s personal income tax returns.
The C corporation files its own tax return and pays income taxes on any net profit at the corporation level. The corporate owner may also pay tax again on any dividends received from the corporation.
The real estate may also be held in a trust. The trust may elect to be taxed similarly to an LLC partnership or a corporation. Thus, it may just report the rental income or expense and have it flow through to the owner’s personal return, or it may report and pay tax on the trust tax return.
These “choice of entity for real estate” decisions create a number of tax planning opportunities. Suffice it to say that it is not common for real estate to be held in C corporations. It is often not advantageous to hold property in S corporations. It is common and often advantageous to hold real estate in LLCs taxed as partnerships. It is also common for real estate owners to form S corporations to manage their properties. It is also common to use one or more of these types of entities to facilitate the transfer and minimize the tax on the transfer of real estate.
How is Real Estate Income Taxed?
Income from real estate usually consists of rental income and gain from the sale of real estate.
There are nuanced tax rules that say what items are or are not considered income for income tax purposes and, if it is income for tax purposes when the income has to be recognized, and what tax rate applies to the income.
What is Considered Rental Income & What Tax Rate Applies to Rental Income?
Rental income refers to the income from renting out a property. This can also include fees, such as pet fees, application fees, and even late fees.
When someone rents out their property for a period of time, they may require the tenant to put up a security deposit as a form of insurance so that the tenant will follow the terms and conditions of the lease. Security deposits are not considered income for the landlord until the time the landlord has the right to keep the security deposit. This is usually the time the lease terminates and after the landlord notifies the tenant that the deposit is being kept to make repairs to the property. Until this time, landlords generally do not need to report security deposits as taxable income.
Rental income is generally taxed at ordinary tax rates. These rates are higher than the capital gains rates.
Depending on the state where the property is located and in which state the owner lives in, one or more states may also impose an income tax on the rental income.
What is a Gain from Real Estate & What Tax Rate Applies to Gain from Real Estate?
Gain refers to the net profit earned on the sale or disposition of real estate. This is usually the amount realized by the seller, which is usually the purchase price offered by the buyer. This amount is reduced by any allowable closing costs that the seller paid.
Gain is also reduced by the owner’s tax basis in the real estate. Tax basis is usually the amount the owner paid for the property (cost basis) plus the cost of any capital improvements made to the property. This is referred to as the taxpayer’s “adjusted basis” in real estate. The adjusted basis can be the fair market value for inherited properties.
It should be noted that the adjusted basis is increased by any depreciation that was taken or could have been taken for the property. Our tax laws add these deductions back to “recapture” the deductions taken (depreciation is a tax deduction that is usually allowable before the property is sold when the property is first placed in service).
The amount remaining after this is the owner’s gain on the sale or disposition of the property. If the amount is a negative number, it is the owner’s loss.
This amount is typically subject to tax at the lower capital gains tax rates. The depreciation recapture may be taxed at a flat 25 percent.
In addition, these amounts may be subject to the 3.8 percent net investment income tax.
Depending on the state where the property is located and in which state the owner lives in, one or more states may also impose an income tax on the gain.
What Real Estate Investment Expenses are Tax Deductible?
Real estate expenses can generally be classified as rental expenses and carrying costs. These real estate tax breaks can save you a considerable amount on your taxes.
Rental expenses are just what the term implies. They are expenses incurred for real estate that is held for the collection of rental income. Carrying costs are similar but more limited. Carrying costs are expenses incurred to hold investment property that is not being rented out. This usually involves raw land or farmland.
These expenses do not include those for real estate that is used personally. Other than property taxes and interest on a second home, expenses for real estate that is used personally are not deductible. These expenses also do not include amounts that are unreasonable.
Real Property Repairs Deduction; Are Improvements Deductible?
Expenses incurred to repair and maintain real estate are deductible. To be deductible, these expenses can not be for a betterment, a restoration or to adapt the real estate to a different use.
Expenses that are a betterment, restoration, or adaptation are considered improvements to the real estate. Expenses for improvements to real estate are not immediately deductible. If the expense is for one of these items it has to be capitalized and the cost recovered through depreciation deductions over time.
Can I Deduct Property Management Fees for Real Estate?
The property management fees are typically paid to an independent company that oversees rental properties and ensures that tenants are taking care of them properly. Property management fees for real estate is tax-deductible. This deduction can include actual cash paid to the property manager as well as free rent provided to an on-site property manager.
Can I Deduct HOA Dues for a Real Estate?
Homeowner association dues are not just a way to maintain a community. They can also be beneficial for the landlord who has to pay them, because they are tax-deductible. In order to qualify as a tax deduction, the homeowner association must have a common interest in maintaining a home or a neighborhood.
Can You Deduct Insurance on Rental Property?
Insurance costs for rental real estate are generally tax-deductible. This includes fire insurance premiums, hazard insurance premiums, flood insurance premiums, earthquake insurance premiums, and windstorm insurance premiums.
Mortgage Interest Deduction for Rental Property
Interest paid on any mortgage obligations incurred for rental or investment property is generally tax-deductible as other rental expenses are. Interest can be deducted on more than one house.
These expenses can even be deducted on Schedule A as itemized deductions if the real estate is used personally.
Can I Deduct Property Tax on a Rental Home?
Real estate that is rented out or used for business purposes may be eligible for a deduction on the property tax.
Deprecation Deductions for Rental Property
Depreciation is the process of allocating the cost of tangible property over its useful life. It is an accounting method that can be used to determine the annual depreciation expense, or simply how much of a given asset’s value has been used up in a tax year.
Depreciation is the reduction in the value of an asset over time. It is a method for recognizing and spreading out the cost of an asset to avoid over-taxing profits.
A depreciation deduction is one type of deduction available to taxpayers, and this type of tax deduction can be used for tangible and intangible property. Numerous items qualify for this tax deduction, like equipment, computers, furniture, cars, trucks, etc.
The depreciation amount that can be deducted from income each year depends on how long it will take before the property will no longer be useful. The IRS has depreciation schedules that dictate how much depreciation can be taken each year depending on what type of property it is and how old it is.
There are quite a few rules for depreciation deductions. This includes the 100% bonus depreciation rules that allow for immediate expensing of the costs incurred to acquire or improve real estate. These bonus depreciation deductions can be sizeable. They can significantly reduce the real estate owner’s income taxes.
Depreciation deductions warrant special consideration and advanced tax planning.
Advertising Costs for Rental Property
The owner of real estate may deduct the cost of advertising the property, such as in newspapers or on billboards.
Can I Deduct Professional Services for Rental Property?
Tax return preparation and bookkeeping fees
Tax return preparation and bookkeeping fees for real estate are fully deductible. These expenses should be deducted on Schedule E or Schedule C and not on Schedule A.
Legal fees for an eviction
Legal fees for evictions are fully deductible.
Deducting Travel Costs for Rental Properties
Travel costs are tricky for real estate. Generally, the IRS takes the position that these expenses are not deductible. This is true even if the real estate owner keeps detailed mileage logs and records. This is because the IRS considers these to be personal expenses. The courts may not reach the same conclusion as ordinary and necessary travel expenses are deductible if the real estate activity is a trade or business and the expenses are substantiated.
Can I Deduct Expenses Paid for By the Tenant?
Expenses that are paid for by the tenant are not deductible by the landlord. The landlord can only deduct expenses they actually pay. There are nuances here, however. For example, rent concessions for the tenant to make repairs may be deductible by the landlord. This is true even if the tenant actually pays for the repairs.
QBI Deduction for Real Estate
The Qualified Business Income (“QBI”) deduction enables some real estate owners to deduct up to 20 percent of their qualified business income from their taxable income. This deduction is available to those who own at least one rental property and operate it as an active trade or business. The IRS issued Notice 2019-7 to create a safe harbor for landlords to qualify. This eliminates the question as to whether rental real estate is a trade or business. Rental real estate that does not meet the requirements of the safe harbor may still be treated as a trade or business for purposes of the QBI deduction if it is a section 162 trade or business. If this is met, there are still wage and property tests that have to be met. There are ways that real estate owners can maximize their QBI deduction while sidestepping the wage-and-property-test restrictions. This is another area where advanced tax planning is warranted.
Real Estate Loss Deduction: Why is My Loss Not Deductible?
Real estate losses have to run a gauntlet of rules to be deductible. This includes the passive activity loss rules, the excess business loss rules, the tax basis limitation rules, and the at-risk rules. The passive activity loss rules are generally applied first, so they warrant additional consideration.
The Passive Activity Loss (“PAL”) rules were enacted by Congress in 1986 to combat perceived abuses by high-income earners who were using real estate losses to offset their non-real estate income.
Rental activities are deemed to be passive. The PAL rules generally limit losses on passive activities to the amount of income earned from the activity. The amount of PAL available depends on the owner’s activity level. Congress created several tests that measure the owner’s activity. These “material participation” tests are nuanced.
Suffice it to say that losses up to $25,000 are deductible despite the PAL rules if the taxpayer makes less than $150,000 a year. Losses of any amount are allowable if the taxpayer qualifies as a “real estate professional” (and there are other nuanced rules that say whether an individual (or their spouse) qualifies for this status).
If the real estate owner cannot satisfy these rules, then their rental losses are limited to their real estate income each year. If the losses exceed the rental income, then the excess amount is suspended and carried forward to the next year. These unused PALs can carry forward for twenty years–if not used up before then or if the real estate is not sold by then.
The loss itself is reported on Form 1040, Schedule E, Supplemental Income, and Loss, or Schedule C, Profit and Loss from Business. The loss is tracked on Form 1040, Form 8582, Passive Activity Loss Limitations. The sale of real estate is reported on Form 1040, Form 4797, Sales of Business Property.
How and why the sale is reported on these forms depends on the facts and circumstances. This is yet another area that warrants careful tax planning.
What Records Should I Keep?
The IRS has a penchant for auditing real estate owners. The myriad of tax rules to apply to real estate provides ample opportunity for auditors to make adjustments.
Unfortunately, this means that real estate owners have to keep very detailed records. This can include invoices and receipts for every expense for the real estate. These records have to be kept until the expense has been deducted and at least three years after that year. So if the expense goes into a PAL carryforward and that PAL is not used for 15 years, the owner would need to keep the records for at least 18 years.
The same applies to capital expenses. These records add to the basis of the property. Thus, the owner has to keep these records as long as they own the real estate.
The real estate owner may also have to keep diaries or calendars to document their activities in real estate. This documentation may show that the real estate is a trade or business or investment, that the owner did or did not actively participate in the real estate, etc. As noted above, real estate owners may find it advantageous to take different positions on these issues. So this documentation can be helpful, even if it is showing that there was no or little activity.
Even record retention requires planning. These are issues that should be considered in executing the real estate tax strategy.
Investment Property Tax Planning
These are just a few of the tax planning opportunities associated with real estate. There are quite a few other opportunities, including Section 1031 exchanges, Section 1033 involuntary conversions, casualty losses, partial asset dispositions, opportunity zone funds, cost segregation, tax planning for demolished buildings, and more. These are just a few tax benefits of real estate investing. And this does not even touch on REITs, syndications, and other real estate holding and investing options.
Should I Buy Real Estate Just for the Tax Advantages?
Real estate can help save money on taxes; however, real estate generally should not be purchased just for tax advantages. Tax savings are not everything.
Real estate is also risky and requires work. Tenants and others do sue landlords. Real estate can lose money and value. The property can be damaged and insurance may not cover the damage.
These risks and potential drawbacks have to be considered in light of the owner or investor’s overall risk tolerance and investment plan.
Experienced Real Estate Tax Attorneys
Income tax planning for real estate is complicated. Our tax laws seem to change every year. This makes it difficult to keep up to date with the latest developments. What worked to save taxes a few years ago may not work today.
We help clients with income tax planning for real estate. If you have tax questions about income taxes and real estate, we want to hear from you. Contact us at (713) 909-4906.
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