As the year draws to a close, so does the deadline for many tax deductions. If you’re a real estate investor, these deductions may be more top of mind than most people. After all, one of the reasons that many people invest in real estate is not just to generate income but also to reap some tax benefits.
I talked with an experienced investor and two financial planners about steps you should take before December 31 to maximize tax advantages if you own residential rental property, or if you’re planning to “flip” property you own now. Note that if you live in a property as your primary residence, you are an owner-occupant, and the tax rules, especially around what you can deduct, are very different.
One caveat: I am not a tax expert, so the suggestions in this blog post are educational and informational only. Consult your tax advisor about your specific situation. This brings me to my first tip:
Don’t try to do your taxes on your own.
If you’re an experienced real estate investor, you already know that real estate tax law is extraordinarily complex. And if you’re a new investor or thinking about investing, it’s something you should be sure you understand before you dive in.
While you may be tempted to try to wing it with do-it-yourself tax software in an effort to save money, it’s NOT worth the risk. Everyone’s situation is different. It will be well worth your time and money to talk with your accountant or tax advisor to make sure you follow the best approach for your deductions. And consult your tax professional long before year’s end—and long before tax season ramps up.
Gather all of your tax-related documents in one place—now.
How often have you scurried around to gather tax documents in April when it comes time to prepare your tax returns? Make things easier on yourself. Get a large envelope and in very large bold letters mark it “Tax Documents.” Keep it near the place where you set down your incoming mail, and put any tax-related documents into it as soon as you receive them.
“Often people don’t even open an envelope marked ‘Important Tax Documents,’ believe it or not,” says Duane Haaland, E.A., of Pacific Financial Income Tax Services in Roseburg, Oregon.
If you bought, sold or refinanced any real estate during the year, the escrow company will have sent you a final closing statement, also known as a HUD-1 Settlement Statement. Be sure to include this document in your current-year tax documents, because it contains information that will be very relevant to the tax return.
Tax Tips for Flippers
We define home flipping as the practice of buying a home, repairing and improving its features, and then putting it right back on the market for a quick (and hopefully profitable) sale. Flipping can also include “wholesaling,” where one buys a home cheaply (at a courthouse auction, for example), and without doing anything to improve it, flips it to someone else for a few thousand dollars in quick profit.
Here are some things you should keep in mind for tax season if you flip homes. As always, consult with a tax advisor about your specific situation.
The IRS will probably treat your flipping activity as “a trade or business” and your flips as inventory.
You and your tax advisor should have a firm understanding of what the IRS treats as a “trade or business” and what it treats as a capital asset that can be bought and sold. For property “flippers,” the IRS considers the buying, renovating and selling process as a trade or business rather than a capital investment.
“If you’ve bought and sold multiple properties in a year, the IRS looks at those properties as inventory,” explains Haaland.
Here’s why that matters. Income from a trade or business is treated as ordinary income (think Schedule C), and net profits are taxed at a much higher rate than the maximum capital gains rate because they’re subject to self-employment tax in addition to the marginal rates of ordinary income tax. Ordinary income can only be offset by net operating losses; self-employment income is never netted against capital gains or losses.
Try not to flip a property and close on it right before the end of the year.
Taxes take a big bite out of the proceeds of a flip, so you may want to delay your closing until 2016. But if you buyer insists on closing before year’s end because they want to file for a homestead exemption for tax purposes (they have to be in possession of the property on January 1 to qualify), it might be worth your while to pay the amount your buyer would save by paying some of his or her closing costs, suggests Ethan Roberts, a real estate writer and Realtor who’s been investing in real estate since 1995.
If you’re rehabbing a property, buy your materials now.
If you’re planning on buying a property to flip near the end of the year (and a lot of people do close on December 30 or 31), you should buy materials now rather than in the New Year, so that the expenses are tax deductible for the same year, says Roberts.
Do repairs before the end of the year.
If you’re hiring someone to do repairs on an investment property, have the contractor perform the repairs now so you can take the deduction for this year.
“Typical repairs like fixing a fence, having the heating or air conditioning unit repaired, or fixing broken pipes may all be tax-deductible costs for flippers,” says Roberts.
However—and this is a big “however”—the IRS may consider some major “repairs,” such as re-roofing, as improvements rather than repairs, and you may have to depreciate the cost over several years. While this may be more applicable to landlords than flippers, consult your tax advisor.
Have your property inspections done now.
Similar to the previous tip, if you have the property inspections on your flip done before December 31, you may be able to take the deduction for this year.
“You may even be able to deduct a portion of the car expense for driving to the property,” says Roberts.
Tax Tips for Landlords
If you own residential property that you rent out, there are some specific tax tips you should keep in mind.
Talk to your accountant before assuming that a “repair” is tax-deductible.
With ongoing rental properties, landlords must depreciate some expenses over several years as “improvements,” while others can be deducted in full during the year the “repair” is done. But it may not be clear which is which.
“You ‘fix’ a leaky faucet with a new washer,” Roberts says. “Repair, right? Easy. But what if you replace a leaky faucet with a new faucet? Repair or capital improvement? You could make a case either way.”
The bigger the repair, the trickier this issue becomes. Roberts gives another example.
“Let’s say the rental’s roof is getting old, and you decide to re-roof the house before you run into problems,” he says. “That might be considered a capital improvement, and you have to itemize the cost over several years. But now what if the roof is already leaking, and water is getting into the house? If you have that fixed or put a new roof on, was that a repair or an improvement?
Moral of the story? Work closely with your tax advisor when you’re deducting expenses.
Consider delaying rent payments.
Depending on how your tax situation looks, you may want to defer some income to next year. One way to do that is to ask a tenant who routinely pays rent before the first of the month to delay their payment until January 1, suggests Roberts. That way, the income goes on your taxes for next year rather than this year.
Think about paying HOA dues before the end of the year.
If you’re renting out property such as a townhome or condominium, the homeowners’ association dues you pay are tax deductible. If these fees are due in January or February, consider paying them early to get the tax break for this year, Roberts suggests.
Now let’s dip into some more complicated tax issues for landlords.
Understand the difference between passive and non-passive rental income.
The IRS classifies real estate rental income as either passive or non-passive (also called “active”) income. In most cases, the IRS considers real estate rental income to be passive income unless you are a qualified real estate professional (more on that in a bit). Examples of non-passive income include wages, business income, or investment income. Both types of income are taxable.
Understand the difference between passive and non-passive losses, too.
Here comes the fun part. You can’t use passive losses—or income—to offset your losses or income from non-passive activities. For example, if you lose money on your rental real estate, you can’t deduct that loss to reduce your wages or self-employment income.
“Let’s say you bought a house in San Francisco that’s generating $100,000 in income, but after you deduct interest, depreciation, repairs, maintenance, property, you have a $30,000 loss,” says Eric Rigby, founder and principal of Rigby Financial Group in New Orleans. “You think, ‘Wow! This is great! I can deduct that $25,000 against my $200,000 salary!’ Not so fast. You have to look at the rules and determine whether you’re a passive or active real estate investor.”
That’s because, as usual, there’s an exception. If you or your spouse “actively participated” in passive rental real estate activity, you can deduct losses up to $25,000 from your non-passive income (like your wages). You actively participate if you make key management decisions, such as approving tenants, setting rental terms, or determining and approving appropriate capital expenditures, explains Rigby.
But wait! That $25,000 is reduced if your modified adjusted gross income exceeds $100,000—and eliminated altogether if your MAGI is higher than $150,000. So the person making $200,000 in our example above is out of luck.
Find out if you could qualify as a real estate professional.
There is a situation in which your rental real estate activity might not be considered passive—and that’s if you’re a “qualified” real estate professional. But the requirements are strict: you must materially participate in these activities, meaning that they must represent more than half of your total personal services and total more than 750 hours per year.
Document the time you spend on real estate activities.
If you want to be considered a real estate professional, be sure to document activities such as consulting with architects and contractors, site inspections, and interviewing potential tenants.
“This documentation can help demonstrate to the IRS that you are materially participating in managing your properties,” says Rigby.
It’s best to document the activities as they happen, but you could just make a reasonable approximation of the hours you spent. However, you should back up your estimates by appointment records, calendars, and/or narrative summaries.
If you want to dive into the details of passive activities, a good place to start is Publication 925 from the IRS.
As you can see, I wasn’t kidding: real estate taxes are extraordinarily complex if you’re investor. I haven’t even begun to scratch the surface of the various requirements and exceptions. Use these tips to help you understand what your tax advisor is talking about when you meet with him or her—a meeting you should schedule sooner rather than later.
