By Kellye Fox
Tax season is here! For those who base their financial income in real estate investments, this is the time of year when Uncle Sam wants to share in your profits. While every real estate investor is different, some of the tips should apply to you. Please note that this article is informative in nature and research-based, but not legal advice. Be mindful to keep accurate real estate records and you should consult with your tax accountant or lawyer for more specific tax concerns, procedures and forms.
How to invest in Real Estate
Once you have decided to enter the world of real estate investing, it is advisable to take a little time to learn the Internal Revenue Service’s (IRS) tax codes, as well as the basic tax procedures and exemptions of your state. Now, with all of the legal jargon out of the way, here are ten tax tips to ease your wallet this season.
1. Holding Pattern
Property kept less than a year (but not owner occupied) and sold is considered a short-term gain and can be taxed at ordinary income tax rates as high as 35%. To avoid a high tax rate, consider living in it over a year, then selling the property (long-term capital gain). This will allow you to be taxed at about 15%. An even better alternative is if you own and live in a property for two years (does not have to be consecutive) because you will not have to pay any tax from the sale. The only caveat is that the condition of the home that you buy has to be equal to or of greater value than your sold property.
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.
*********************************************************
Kellye Fox is a Realtor® with Property Consultants Realty. She can be reached via e-mail at kfox@propertyconsultants.com or at
312-492-3234.
