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2. 1031 Exchange (Internal
Revenue Code Section 1031)
This tax tip is probably
the most recognized of all. It is applicable if you're planning to buy a
property, but not live in it. Normally, a property owner is taxed on any
gain from the sale. In this type of transaction, you can defer taxes owed on
the property if you trade it for another of like kind, same nature or
character. For example, you can trade your residential rental home for a
commercial property. The 'like' property must be an asset that produces
income, not a personal residence. A taxpayer only has 45 days after the date
that the property is transferred to locate a maximum of three replacement
properties. Additionally, the exchange must be closed within 180 days after
the transfer of property. No extensions are given to meet the time limits.
Keep in mind that you are NOT avoiding paying a tax, but deferring the tax
payment, which allows you to have more money available to invest in another
property. Another note to mention is that the 1031 Exchange is not limited
to real estate. Property held for productive use in a business, trade or
investment is eligible.
Please refer to Section
1031 of the IRS code for more information on the requirements for a valid
exchange, different types of exchanges and general guidelines.
3. Property Management
Investors who leave the
day-to-day details to a property manager, but still participate in major
decisions like repair policies and tenant selection, can gain when it comes
to taxes. There's no question that property managers are important to owners
who are sensitive to location or time restrictions. Real estate investors
who meet the 'material participation test' of owning a minimum of 10%
interest can enjoy the maximum tax benefits. The allowance is a deduction of
up to $25,000 of your investment property losses against your taxable
income, only if your adjusted gross income is less than $100,000. Most
property losses are called 'paper loss' (rather than actual cash loss),
because they aren't out-of-pocket losses. Most paper losses come from
depreciation deductions. Commercial properties are deductible over 39 years
and residential rentals for over 27.5 years.
4. Rental Income
According to the IRS,
rental income is defined as any payment you get for the use or occupation of
property. Your gross income must include all amounts you receive as rent for
the year you actually or constructively receive it. The expenses of renting
property can be deducted from your gross rental income. Security deposits
do not need to be included in your income if you plan on returning it to
your tenant at the end of the lease. However, if you plan on keeping part or
all of it during any year because the lessee did not live up to terms of the
lease, the amount to be kept should be included in your income that year.
Also, if your tenant pays any of your expenses, those payments are rental
income and must be included in your income. Lastly, if your tenant provides
property or services in lieu of rent (i.e. paints property instead of paying
two months rent), the fair market value of the property or service should be
included in your rental income (i.e. the amount the tenant would have paid
for two months rent).
Please refer to Publication
527 of the Internal Revenue Service for more information about Residential
Rental Property.
5. Tax-Free to Taxable
(Internal Revenue Code Section 121)
To piggy-back on the
subject of rental income, there is a code on the IRS books that new real
estate investors need to know about. Imagine that you bought a new home and
instead of selling your principal residence, you decide to rent it out.
The standard Section 121
says that if you owned and lived in a home for at least two of the last five
years, you don't pay tax on the first $250,000 of gain ($250K for singles;
and $500K for married couples and those filing jointly). However, since
that principal residence was turned into a rental, that tax-free gain
converts to taxable gain if the property isn't sold in the first three
years. There are two key notes to remember about Section 121. One is that if
you don't have any appreciation in your old home (the one to be rented),
you're not losing the capital gain benefit by converting to a rental.
Secondly, if you do have a lot of appreciation and you want to use that
equity to buy a rental, consider selling your old home, then using the
tax-free gain to purchase a rental.
6. Improvements
Some real estate investors
are under the assumption that they can write off all of the amounts they
spend to improve a property. Any expense that improves the utility
(usability) and/or increases the life of the property needs to be
depreciated over the next 27.5 years for residential or 39 years for
nonresidential. Bottom line, the money spent improving or renovating a home
cannot be written off except through depreciation. That $10,000 you spent to
fix up your investment property will be slowly written off over the next
decades. Instead, maintain the property as well as possible as you go. For
example, general repairs, new carpeting and repainting should be deductions
in the year of the expenditure.
7. Property Taxes
As a general rule,
taxpayers can deduct property taxes on all of your personal holdings, but
mortgage interest can only be deducted on your primary residence and one
other home, up to $1.1 million of combined debt. According to Forbes.com,
they may be able to be 'bundled' condensing them into the same year, if you
do not have enough itemized deductions for a given year. This will allow
for a bigger deduction. By doing this, you may be paying your property taxes
in advance to take advantage of the deduction in a particular year. Speaking
of property taxes, if you feel that the assessment conducted on your home is
not accurate, you can contest it in the future. The protest could payoff
with a tax refund or a reduction in future assessments.
8. How to Depreciate
Property (Internal Revenue Code Section 179)
The Section 179 deduction
of the IRS allows a sole proprietor, partnership or corporation to fully
expense tangible property in the year it is purchased. According to an
article on Marketwatch.com, Section 179 allows you to deduct up to $108,000
of costs that would normally be appreciated and capitalized. So, that
equipment and furniture you bought in 2006 and put into service can qualify
you for the deduction. The property has to be considered personal property,
not real property. Therefore, you cannot deduct those new windows you
installed in a rental property.
9. Thinking of marriage?
This may be a weird tip to
include, but it could be helpful. If you are considering selling your house
and getting married in the same year, you might want to re-think that if
your mate has been living with you. As we learned in Tip #5, when you sell a
home, $250,000 of that profit is tax-free (double that for married couples).
The only thing to remember is that your mate should have lived at that home
for at least two years.
10. Define Yourself
My last tip has to do with
what a definition of your work is, instead of a tax deduction. The IRS has
different definitions for real estate investors. There's the dealer,
developer, professional and investor. Which one are you?
- Real estate dealers buy
and sell real estate for short-term profits. They are the flippers or
rehabbers.
- Real estate developers
renovate or change the property.
- Real estate
professionals are those who are involved in real estate activities, own 5%
or more of their business and spend a minimum of 750 hours in real estate.
- Real estate investors
buy property with the intention of holding them and gaining a financial
return.
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Kellye Fox is a RealtorŪ
with Property Consultants Realty. She can be reached via e-mail at kfox@propertyconsultants.com
or at
312-492-3234. |
