Real estate is one of the proven ways to build wealth over the long term, as it generates passive income, and property prices tend to appreciate over time. At the same time, there are pitfalls associated with real estate investments, as landlords are required to pay taxes for any income generated from them. In fact, the IRS treats rental housing, short-term stays, commercial units, and development projects differently, and each category has its own unique tax responsibilities.
To help you navigate through these tax provisions, this guide lays down the real estate tax rules and ways by which you can legally reduce your tax burden.
Understanding Real Estate Tax Basics
The real estate tax in the U.S. is ad valorem, which means it is based on the value of the property in the year of valuation. These are levied by each state and paid annually. The proceeds are used to fund the local schools, roads, emergency services, and other public utilities.
What Counts as Taxable Income for Landlords
Almost any income earned by a landlord from a property is considered taxable income. It includes:
- Monthly rent and any advance rent obtained from tenants.
- Other fees, like late fees, pet fees, or parking fees, are charged to the tenants.
- Security deposits. However, this is not included if the landlord has to repay the amount to the tenant at the end of the lease. Only the amount that is retained due to damages caused by the tenant is considered income.
- Any amount paid by the tenant to cancel a lease.
Key IRS Forms Every Real Estate Investor Should Know
Topic 414 lays down the forms that must be used for reporting incomes from property. Here are some notable ones you should know:
- Schedule E (Form 1040) – To report rental income and expenses.
- Schedule C (Form 1040) – As profit or loss if this is a primary source of business revenue or if you offer additional services to your tenants.
- Schedule 1 (Form 1040) – Any additional income or adjustments earned from the property, like lease cancellation payments.
- Form 4562 – Depreciation of property.
While filing these forms, make sure to have them back with supporting documents.
The Difference Between Active and Passive Real Estate Income
The difference between active and passive income is the involvement of the landlord. An income is active if the landlord puts in time, effort, and money. Some examples of active involvement are:
- Property development
- Flipping properties
- Offering additional services to tenants, like home stays
All this income is treated as regular income and is subject to self-employment taxes.
On the other hand, passive income is where the landlord is not involved at all. It includes:
- Long-term rental properties
- A limited partner in a real estate business
- Earning from real-estate trusts and REITs
There are no self-employment taxes in these incomes. However, the losses can be offset only against other passive sources.
Understanding this difference is key to evaluating your tax obligations.
Essential Real Estate Tax Planning Strategies
Real estate taxes can quickly add up. This is why it’s important to understand the eligible deductions and plan well using different strategies to minimize your taxes.
How to Maximize Rental Property Deductions
All ordinary and necessary expenses can be claimed as deductions. However, the key is tro track these expenses, understand what falls in this category, and maintain the required documentation.
Depreciation Benefits for Real Estate Investors
Depreciation is a significant deduction that helps you recover the cost of your property over its useful life. For residential properties, it is depreciated over 27.5 years for residential properties and 39 years for commercial properties. Furnishings and appliances in a rental property can be depreciated over five to seven years.
Using Cost Segregation to Accelerate Tax Savings
Cost segregation is a cost strategy authorized by the IRS and applies to the landlords of commercial and residential rental properties. Under this provision, you can increase immediate cash flow and accelerate depreciation deductions. Instead of the standard depreciation of 27.5 or 39 years for a property, you can identify and reclassify certain components and depreciate their value over shorter times.
Managing Repairs vs. Improvements for Optimal Tax Treatment
Repairs and improvements are extremely complex from an accounting standpoint. Repairs can be deducted as operating expenses in the year they occur, as they are deemed necessary to maintain the property. Improvements, on the other hand, are expenses undertaken to add value and extend the useful life or the income earning potential of the property. This is why it is treated as a capital expense and recovered through depreciation and cost aggregation.
Advanced Real Estate Tax Strategies for Growth
Many landlords prefer to leverage advanced real estate strategies for growth and long-term wealth accumulation. There are also risks that come with some of these strategies, so it is best you take the help of experts like Manay CPA.
1031 Exchange: Deferring Capital Gains on Property Sales
A 1031 Exchange, also called like-kind exchange, is an option that allows the investor to defer capital gains and other related tax liability on the sale of a property, provided the proceeds go into buying another property within specified time limits. This process continues until a property is sold for cash. However, this option is available only for properties held for business or investment.
Using LLCs and Entities for Real Estate Tax Efficiency
Holding a rental property under LLC offers pass-through taxation. This means the LLC does not pay federal taxes, but passes them to the owners, who pay the tax as a part of personal returns. Additionally, it adds liability protection and a legal separation of personal and business assets. It can also simplify recordkeeping.
How to Handle Capital Gains When Selling Investment Properties
Handling capital gains is another complex process that involves the following steps:
- Calculate your adjusted basis, which is the original purchase price of the property plus any improvements made on it minus the depreciation claimed over the years (even if depreciation was not actually claimed, the IRS treats it as claimed and requires it to be deducted from the basis)
- Subtract this value from the selling price to calculate the profit or loss.
- Determine the holding period, as any property held for one year or less is taxed as ordinary income tax rate, while any property over a year is treated as capital gains.
- Maintain the required document and use Form 4797 to report capital gains.
Opportunity Zones and Long-Term Investment Tax Breaks
The IRS offers something called an Opportunity Zone through a Qualified Opportunity Fund (QOF). By investing the proceeds of capital gains in this fund, you can defer tax payment, reduce the taxable gain, and pay no tax on new growth if it is held for more than 10 years.
Common Real Estate Tax Pitfalls to Avoid
Real estate tax is complex. Even small missteps can increase tax liability and this is why you must stay away from pitfalls. If you are unsure, reach out to experienced CPAs who can help you with the process.
Overlooking Passive Activity Loss Rules
The IRS limits how much money can be claimed as a loss from passive income rental properties. Moreover, this loss can be offset against another passive income source only.
Misclassifying Personal vs. Rental Use
Another common mistake is to mix the properties used for personal and rental use, as it can lead to the wrong deductions and depreciations. In general, if you rent out a property for less than 15 days a year, it is a personal property, and you cannot deduct any rental expenses from it.
Ignoring Record-Keeping and Documentation Requirements
Lack or insufficient documentation can lead to IRS audits and even penalties. Maintain clear logs for rental income, repair receipts, lease agreements, capital improvements, and other expenses.
Tax Planning Tips for Different Types of Real Estate Investors
The tax planning strategies can differ based on the type of real investors. For example, residential landlords have different deductions and depreciation rules when compared to commercial property owners.
Residential Landlords
Residential landlords can make the most of depreciation and deductions to bring down their taxable income. They can also tap into long-term stable rent streams for better planning.
Short-Term Rental Hosts (Airbnb, VRBO, etc.)
Short-term rental hosts are taxed differently based on the services they offer. In the case of homestays and rentals where the owner offers services, it will be deemed as active income. If the owner merely rents out the place with no involvement in everyday activities, the income is calculated as passive income.
Commercial Property Owners
Commercial property owners have a longer depreciation cycle, typically 39 years, when compared to the 27.5 years of residential property. However, they have the option to do cost aggregation for higher depreciation limits.
Real Estate Developers and Flippers
Flippers are likely to pay short-term gains or add it to their personal income if the property is held for less than one year. For more than a year, it can be long-term capital gains, and this can be reinvested for kind exchange or placed in a QoF for deferred tax payments. Develops, on the other hand, can claim deductions for the cost of construction, repairs, etch this computation can be highly complex.
How to Stay Compliant with IRS Rules and Deadlines
As a taxpayer, it’s important to comply with the IRS rules and deadlines, as this will help avoid penalties and fines.
Estimated Taxes and Quarterly Payments for Investors
You must estimate your taxes for the year and if it exceeds $1,000, you must make quarterly payments. This is to avoid excess tax burden at the end of the year and to spread your tax payments throughout the year. The payment due dates for each quarter are April 15, June 16, September 15, and January 15 of the following year.
Reporting Rental Income and Expenses Accurately
Another important aspect to stay compliant is to report accurate income and expenses. Make sure to support them with the necessary documentation for compliance.
What to Expect During an IRS Audit
An IRS audit happens when the officers detect discrepancies or insufficient documentation. Prepare for the following during an audit:
- Depreciation schedules
- Expenses and the reasons for their classification, including the necessary documentation to prove your claims.
- Repairs vs improvements.
- Passive activity rules
- Warranty deed
- HUD statement
In general, well-organized records reduce the risk of audits.
Professional Support for Real Estate Tax Planning with Manay CPA
Given the complexity and the many rules involved in real estate taxes, it is best to take professional help as these experts can guide you through the taxation process while maximizing your returns.
When to Hire a CPA Specializing in Real Estate
Hire a CPA specializing in real estate like Manay CPA in the following situations:
- Complex depreciation schedules.
- Mixed use of a property for personal and business purposes.
- Tax planning for multiple properties.
- 1031 exchange structuring.
- Passive loss and its offset.
- Cost segregation
- LLC tax choices.
How Strategic Tax Planning Protects Your Wealth
Professional tax planning lowers your taxable income, leading to wealth accumulation over time. You can even work on setting up long-term strategies like wealth transfers and structuring to meet your long-term objectives. These professionals also help with maintaining records and keeping you ready for audits.
Many CPA specializes in real estate tax planning. Schedule a free consultation today.
FAQ
How can I reduce my taxable income with real estate?
Some common ways to reduce taxable income are depreciation, cost segregation, mortgage interest deductions, repairs, 1031 exchange, and more.
What is the 7% rule in real estate?
This is a rule that real estate investors use while assessing assets or development opportunities. It means that the asset must provide a minimum of 7% return per year. Using the right taxation strategies can help you achieve this rule.
What is a simple trick for avoiding capital gains tax?
A 1031 Exchange is a simple trick that allows you to defer capital gains by investing the proceeds in another investment property. You can also use Opportunity Zones to avoid capital gains tax.
How often should you review your estate plan?
It is a good idea to review your tax plan once every three to five years, or after a major life event like marriage or divorce. Also, real estate landlords must ensure that all documents are up-to-date and reflect the current holding status.
