Costly Mistakes Every Real Estate Investor Should Avoid
When investing in real estate, it is important to discuss your situation with a tax advisor who is knowledgeable in real estate matters. The real estate sections of the Tax Code are some of the most complex. Before you invest in a new property, be sure to find out how it will affect your overall tax picture. Your tax situation may be quite different than your neighbor’s.
Six different people can co-own a parcel of real estate and each experience a different tax treatment when they file their tax returns. Some of the factors that affect an individual’s tax outcome would be whether the investor is treated as passive, active or a real estate professional; whether the investor has other household income that may limit deductible losses; or whether he or she is renting to a family member.
In addition, the tax treatment of real estate can vary dramatically based on whether the property is income property (rented out); investment property (held long term); inventory property (bought or built to sell); the intentions and actions of the investor; whether the property will be used as a residence, vacation home, or a myriad of other factors.
Below are three costly mistakes many real estate investors make when they fail to consider the whole tax picture.
Mistake #1: Not Understanding What Makes Real Estate Expenses Deductible
If the property you purchase is to be used as your primary residence (or your home), then your deductions are limited to mortgage interest (subject to limitations), property taxes, points, and mortgage insurance protection (temporary law).
If you were to buy another house without renting it out, you may be able to treat it as a second home. The deductions for a second home are limited to mortgage interest (subject to limitations) and property taxes.
If you bought a third house or have land that is not rented out, then your deductible expenses are limited to property taxes, and the mortgage interest is classified as “investment interest.” Investment interest can only be deducted against investment income, such as dividends and interest income. Expenses, such as maintenance, fencing, and other land expenses are not deductible except as investment expenses, or they can be added to the cost basis of the property. If the expenses are added to the cost basis, then they would be deducted when the property is sold, thereby reducing the gain or increasing the loss on the sale.
The amount of your real estate expenses that is deductible in any given year is determined by whether you are a “passive” investor or whether you “actively participate” in the rental activity, or whether you “materially participate” in the rental activity.
The IRS deems everyone that holds real estate, other than your personal residence(s), a “passive” investor, unless you can qualify as an “active participant” or “material participant.” If you do not qualify as an active participant, then your losses are considered passive and can only offset other passive types of income, such as interest, dividends, or income that flows through to you from limited partnership K-1s, or other such investments.
Passive losses that are greater than your passive income cannot be deducted immediately, but are to be carried forward to future years. This carry forward is called a Passive Activity Loss Carry Forward and is tracked on your 1040 tax return.
An investor who actively participates in rental activity is allowed to deduct certain expenses up to $25,000 more than the income taken in as rents. For example, if you collected $10,000 in rents, but had $37,000 in deductible expenses and depreciation, then you would take a $25,000 rental income loss and carry over the $2,000 balance as a Passive Activity Loss Carryover (subject to income limitations). Costly Mistake #2 is all about these limitations.
Mistake #2: Buying a Rental for Tax Benefits without Considering Limitations
If you bought a rental property because you wanted to deduct rental losses against your other income in order to reduce your income taxes, then you may be disappointed. The tax law contains passive-loss rules that limit deductions (see Costly Mistake #1).
If you, the real estate investor, want to be able to deduct rental losses, you need to qualify as an “active participation” owner. To be an active participation owner you must participate in the day-to-day management decisions of the property or properties, or be actively arranging for others to provide services (such as repairs). Management decisions include such things as approving new tenants, deciding on rental terms, and approving capital or repair expenditures.
You are treated as actively participating even if you hire a property manager or others to provide services, such as repairs. Your lack of participation in operations does not prohibit your qualifying as an active participant as long as you are involved in significant decision making.
As an investor with rental income properties, you can qualify for the full $25,000 rental property loss deduction IF you actively participate in the rental AND your modified adjusted gross income is $100,000 or less. The law phases out your deductible loss at a rate of one dollar for every two dollars of modified adjusted gross income in excess of $100,000, with full phase-out reached at $150,000. The phase-out amount is not deductible on the current tax return and should be carried forward for a deductible benefit sometime in the future.
Beware if you file married filing separately (MFS). There is no passive loss allowed if you file MFS and you lived with your spouse during the year. If you did not live with your spouse during the year and file MFS, then the $25,000 loss is reduced to $12,500 and the income ceiling is reduced to $50,000.
So, you can see why so many people that buy a rental property are disappointed at tax time. You should always get the opinion of a tax advisor before making a large investment.
Mistake #3: Failing to Maximize Allowable Rental Losses
If you find yourself slightly over the income level that disqualifies you from benefiting from the full $25,000 loss, a little planning and restructuring can modify your income to put it in the range for you to qualify for the full $25,000 loss on your rental properties. Or, if you are not able to take the full loss benefit, then perhaps you can modify your income enough to take a partial loss benefit.
You can benefit greatly if you are able to take the actions needed to reduce your modified adjusted income below $150,000 for a partial benefit, or preferably, reducing it to the $100,000 level to qualify for the full $25,000 income loss benefit. This loss can be used to offset other ordinary income on your tax returns, thereby reducing your income taxes.
One strategy that could be enacted to reduce your modified income is to increase your tax deductible contributions to an employer’s retirement plan, such as a 401(k) contribution, thereby reducing taxable wages.
What if you are self employed? You can reduce your profits from self-employment by increasing Section 179 deductions. This can be accomplished by purchasing a new vehicle for your business or buying qualifying equipment.
Strategic timing is the key to fixing Costly Mistake #3. You must know what your modified adjusted gross income is BEFORE the end of the year, so that action can be taken before it is too late!
By Randy Roth, EA, CSA, MSFS
The foregoing is intended to provide general information, not specific tax or legal advice. For specific advice you should contact your tax advisor, or you can contact us.
About the Author
Randy Roth is a tax, estate & business consultant. His practice concentrates in the areas of tax preparation and planning for individuals, businesses, estates, trusts and non-profit organizations. He is knowledgeable in real estate matters, including the taxation of real estate, estate issues involving real estate, as well as the business of real estate. He can be reached at his firm, Incompass Tax, Estate & Business Solutions at (916) 974-9393. The office location is: 4600 Roseville Road, Suite 150, Sacramento, CA 95660.