Are you taking advantage of all the tax benefits that are available to you as a real estate investor?
The deductions you’re entitled to as an investor can be an ideal way to limit your tax liability and protect your income. The benefits associated with your real estate investments will likely be greater than the tax help you get from any other investments. But, reporting those taxes isn’t exactly easy or straightforward.
We aren’t tax experts, but as property managers we do work closely with investors, and we also handle a lot of accounting that pertains to investment property. In today’s blog, we’re talking about how to leverage your losses into some pretty significant tax savings.
Business Structure and Schedule K-1
Every real estate investment is structured a bit differently, and the way in which you’ve set up your own portfolio will dictate how to file taxes, claim deductions, and make payments. Typically, investors will create a limited partnership or a limited liability company (LLC), especially if they’re investing with others.
If you have an LLC, you’re required to report the financial information that impacts your investments on your individual income tax return. This reporting will be documented on Schedule K-1. The information reported includes your net rental income, any losses, as well as the capital and liabilities of your LLC.
The tax code will sometimes allow the use of a pass-through strategy, which shifts tax liability from the entity to the individuals who have an interest in it. The entity itself pays no taxes on earnings or income; instead, the income and the taxes due on that income will pass directly to the stakeholders.
This is why Schedule K-1 is necessary.
Schedule K-1 is similar to Form 1099, in that it reports dividends, interest, and other annual returns from an investment. Whether you receive a K-1 or a Form 1099 depends on your investment.
Depreciation as a Tax Benefit for Idaho Rental Homes
Depreciation is easily one of the best tax tools for real estate investors, regardless of how you are set up as an investor.
All properties deteriorate as they age, and the IRS allows you to write off part of the loss of value that occurs on your rental home. The IRS has established 27.5 years as the amount of time that residential property depreciates under its General Depreciation System.
This is pretty generous, and it should stick around in the tax code for some time. So, you can accelerate the depreciation loss with your rental property, which will help you lower your taxable income for the year at tax time.
Make sure you’re careful and correct. Here’s what you need to know:
- Depreciation for your rental property is generally reported on Schedule E of a standard 1040, although there are situations in which you would use other forms. For example, Form 4562 may be used if you claim depreciation on a property in the year that you put it into service as a rental property. Consult with your tax specialist before filing.
- You need to meet certain conditions before you’re eligible to claim depreciation as a deduction. Here is what’s required:
- The property must be owned by you.
- The property must earn rental income.
- You must be able to document the useful life of your property. This will depend on the type of rental investment you own. Everything has a different life cycle, or rate at which it wears down. For real estate, this is somewhat standardized and the 27.5 years applies, unless your property is subject to the Alternative Depreciation System, in which case it’s 30 or 40 years (this is rare).
- The useful life of the property must be greater than 1 year. Nothing that wears out in less than a year can be depreciated on your taxes.
If you begin renting out a home in one year and sell it within that same year, you cannot claim depreciation on that property.
Business Expenses Associated with Rental Property
As a real estate investor, you should be treating your rental property as a business. Whether you have one rental home or an entire portfolio, the IRS sees your rentals as a business that earns income. That means that many of the expenses you incur as a business owner are tax-deductible. There are a few things you should always take advantage of when you’re claiming tax benefits.
- Mortgage interest and even other interest paid on property-related loans.
- Insurance costs for your investment properties.
- Professional property management fees.
- Additional professional fees such as accounting or legal costs.
- Maintenance and accelerated depreciation on household items.
- Travel costs involved in visiting your rental properties.
Be careful with your deductions.
The IRS allows you to deduct only the ordinary and necessary expenses for managing and maintaining your rental property. You can make tax deductions for the money you spend preserving the asset’s value and condition. You can also deduct general business costs, for example advertising a vacant property. That’s seen by the IRS as a necessary business expense, so you can deduct that cost.
Maintenance costs are deductible as well, but you have to be specific about what you’re maintaining. And, be careful about what you consider maintenance and what is considered an improvement. The costs of materials and supplies when you’re maintaining your home are deductible. Anything that needs to be done to keep your property in good condition is acceptable.
But, improvements are not tax deductible. The amount you spend keeping your property safe and habitable is one thing. But, you cannot deduct for new wood floors when you decide to replace your carpet. The IRS does not allow you to deduct the cost of improvements that lead to the betterment of your property value.
How to Defer Capital Gains Taxes with Investment Property
Maybe you’ll find yourself wanting to sell a rental property this year. How will you account for that on your taxes?
Well, you will be expected to pay capital gains taxes. The market being what it is, you are likely to earn quite a bit of profit, especially if you have some equity in the property you decide to sell. Your investment property will not qualify for the gain on sale exclusion in the tax code, and the sale of an asset is one area where most investors will always lose money.
Unless you defer the payment of those taxes.
To defer the capital gains taxes you’ll have to pay on the sale of an investment property, we recommend that investors consider a 1031 Exchange. When you take advantage of this tax benefit, you are going to sell one rental property and then use the proceeds to invest in a similar property or a series of properties. It won’t wipe away your tax liability entirely, but it will give you the opportunity to strengthen your investment portfolio and delay paying those taxes.
The 1031 exchange comes with some strict deadlines and requirements, so you have to make sure the money from the sale is held in escrow, which is managed by an intermediary. These are the steps you’ll want to follow with a 1031 exchange:
- Make sure your property qualifies for this benefit. This tax program is meant for investment homes. You cannot sell the home you’ve been living in and reinvest the money to buy a vacation home. It has to be one income-producing property for another.
- You’ll need to exchange with a like property or properties. The new property you choose must have a value that is the same or higher than the original property. If you walk away from the exchange with any profit, they will be taxable.
- Find one property, two properties, or three to exchange with your current property.
- Pay attention to the timelines. You’ll need to identify a replacement property within 45 days of selling your original property. Then, you have 180 days to close on the new sale. The entire exchange must take place within the 180 days (meaning you don’t have 45 days plus 180 days – the clock does not reset). This can be a challenge now, with the market so hot and inventory lower than the demand. Be prepared to move quickly.
- Use an intermediary and don’t take any of the cash from the sale of your property. The intermediary will hold your funds until they can be reinvested in your new purchase. Ask your property managers for a referral.
If this makes sense to you, it’s possible to sell one rental home and invest in another without any of the tax liability that comes with selling investment property. It’s an excellent tax benefit that’s often underutilized by real estate investors.
Don’t be afraid of those real estate losses when it comes to your investment portfolio. They can actually help you at tax time, and if you’ve surrounded yourself with some great property management partners and tax professionals, you’re likely to earn more and lose less on your entire portfolio.
We love working through these issues with new and experienced investors. If you’d like to hear more about how you can leverage tax deductions with your investments, please contact us at Jacob Grant Property Management.