Real estate investors and real estate dealers are taxed differently when they sell their properties. Therefore it behooves you to know the differences between the two to avoid unfavorable tax treatment on their real estate gains. Here are five real estate tax traps to avoid:
Tax Trap #1: Not understanding real estate passive losses
While your real estate investment may be cash-flowing (rent pays the mortgage and the operating expenses), financial statements may still show a loss because you get to write off a portion of the purchase price through depreciation each year. However, there are limits on the amount of real estate passive loss deductions you can take. The U.S. Congress labeled real estate investment a passive activity and said that, except in a couple of special circumstances, you can’t write off passive activity deductions unless overall you show positive passive income. Therefore, it is important to know the rules.
However, there are two strategies that let you write off deductions from real estate even if overall you show a loss from real estate investing:
1. If you’re an active real estate investor with adjusted gross income below $100,000, you can write off up to $25,000 of passive losses annually. (If your income is between $100,000 and $150,000, you get to write off a percentage of the $25,000. Ask your tax adviser for the details.)
2. If you’re a real estate professional, Congress says the passive loss limitation rule doesn’t apply to you when it comes to real estate. You do not have to be a licensed real estate agent or broker to qualify. The tax law instead creates a time-based test: A real estate professional is someone who spends at least 750 hours a year and more than 50% of their time working as a real estate agent, broker, property manager or developer.
Tax Trap #2: Accelerating depreciation when it does you no good
One of the benefits of real estate ownership is that you get to take a non-cash deduction know as depreciation. While depreciation provides a great tax opportunity to reduce taxable income, it does not help you when you can’t take the loss anyway due to real estate passive loss exclusions. Consider investing in a cost segregation study to help you properly maximize your tax deductions.
Tax Trap #3: Thinking that improvements are deductible in the year incurred
Thinking that improvements can be writen off in the year incurred is often a mistake made by real estate investors. Sometimes it comes as an unpleasant surprise when their property improvements cannot be used in the year incurred to lower their taxable income.
Capital improvements are expenditure that increases the life of the property or improves its utility. These expenditures need to be depreciated over the next 27.5 years (if the property is residential) or over 39 years (if the property is nonresidential). You can’t, therefore, write off the money spent improving or renovating a house—except through depreciation.
The solution is to maintain your property in order on a regular basis. Maintenance expenses are deductible in the year incurred (painting, new carpeting, general repairs, etc) subject to the passive loss limitation rule discussed above.
Tax Trap #4: Being classified as a real estate dealer
Real estate investors purchase real estate with the intention of holding their properties and gaining a financial return. Real estate dealers buy and sell real estate as part of their everyday business. Real estate professionals who are involved in “flipping” (i.e. buying real estate with the intention of selling it for a profit in a short time frame) are usually considered dealers. Also, builders and contractors who build houses and sell the finished houses to customers are also considered dealers.
If you’re a real estate dealer, your income is subject to self-employment tax (unless you’re holding it in a corporate structure) and you could have a tax issue if you sell a property on time. When a real estate investor sells property that has been owned for more than one year, any gain on the sale is taxed at the favorable capital gains tax rate. When real estate dealers sell their properties, those properties are considered inventory and any gains are taxed at the dealers’ ordinary income tax rates, which can be as high as 39.6% for federal tax purposes. If a real estate investor sells property that has been owned for less than one year, any gain on the sale is taxed at the investor’s ordinary income tax rate as well.
Tax Trap #5: Thinking that once your classified an investor you are always an investor
The key to avoid being classified a dealer is to have an investment intent, which is documented, showing that you conduct your business with a goal to buy and hold. However, the classification of an individual as an investor or dealer is determined on a property-by-property basis.
If you have questions about the above tax traps, please contact me. If you have other tax traps, please share them.