“The Book on Tax Strategies for the Savvy Real Estate Investor” By Amanda Han and Matthew MacFarland
“A common necessary expense in the real estate world would be
homeowners association (HOA) fees. This expense is necessary, because if you didn’t pay the fees, you could be subject to hefty fines and penalties from your HOA board. Therefore, these payments are legitimate business deductions.”
“As surprising as this may sound, Karen’s travel costs to visit her rental properties are all tax deductible. Her trip is considered ordinary in nature because investors commonly visit their rental properties.”
“Now, you may already know that meals and entertainment can be tax deductible when they are business related. However, the IRS generally only allows us to write off 50% of these costs. For example, if you had a business meal with a client and spent $200, only $100 of that is tax deductible; the rest is not. A small loophole here is that if the meal is provided to the general public, then 100% of the cost is tax deductible.”
“Even if the nanny did not provide any assistance to Eric with his real estate business, he could still claim a childcare tax credit for the money he paid her. This could be an option if Eric had to hire the nanny to watch the baby because both he and his wife worked during the day. However, this would not be directly related to the business and would therefore be only partially deductible on their personal returns.”
“Although older kids can sometimes be paid as 1099 contractors, Erin would
receive a better tax benefit by using the W-2 route, because her kids are both under the age of 18.”
“As long as Erin pays her kids appropriately for the tasks they do, their age
doesn’t matter to the IRS. Of course, Erin does need to make sure she follows her state’s labor laws with respect to the number of hours and type of work appropriate for persons in that age group.”
“As long as the kids were earning an income, they could contribute to a traditional or Roth IRA.”
“One of the best types of retirement accounts for kids is the Roth IRA, because it is a bucket of long-term, tax-free money that can be invested.”
“We suggested that they instead fly down on Thursday as planned and attend the seminar and radio show on Friday. Then they could sightsee and relax on both Saturday and Sunday. Lastly, they could have a tax planning meeting at our office on Monday and fly home on Tuesday.
This way, they could deduct all of their airfare, hotel, and rental car expenses, as well as 50% of their meals over six days without feeling like they were in California only to work.”
“For you to deduct 100% of your travel expenses, such as airfare, hotels, and taxis, you must be able to show that the primary purpose of your trip was for business. The term ‘primary’ simply means that more than 50% of your time is spent on business activities.”
“Saturday and Sunday were reserved for fun activities. This is when they did their Hollywood, Beverly Hills, and beach activities. These days would not be viewed as ‘business’ days because they involved no business activities.”
“Keep in mind that the bus tickets you buy for a tour of Hollywood and the money you pay to rent a surfboard at the beach are still nondeductible expenses. However, your meals for the weekend may still be tax deductible.”
“Now you may not think that the meeting on Monday was all that important for Ellen and Steve, but that Monday meeting is what allowed them to write off their hotel, rental car, and food costs for the weekend.”
“The best way to prove your business purpose is to show that you had
predetermined business activities, meetings, or events set up. These things must therefore be arranged before you leave on your trip.”
“For example, Ellen and Steve registered for the real estate conference before they left on their trip. They have emails from us to confirm that a tax meeting was scheduled before their departure. The documentation for both of these things can prove that there was a predetermined business purpose for the trip. Technically, Steve and Ellen had to have a hotel room on both Saturday and Sunday night because they were waiting for their tax-planning meeting on Monday.”
“The most common travel expense, of course, is cars. Generally, travel-related car expenses are deductible. This can include oil changes, maintenance, gas, repairs, parking, tolls, and depreciation. It is important to hold on to your receipts and keep a travel log so your CPA can calculate how much of these expenses can be used to offset your taxes each year. However, if you have a separate car used exclusively for business, all these expenses may be deducted on your tax returns.”
“Train and airfare tickets are also deductible, plus any baggage fees you incur while traveling.”
“Taxi, subway, and bus expenses are also deductible when you are traveling for business purposes.”
“The tax code states that receipts must be kept for any entertainment expense over $75.”
“Real estate and educational meetings are deductible as well, and not just the registration fee. Travel to and from the event is deductible, as well as any of the aforementioned expenses.”
“The IRS actually introduced this method, believe it or not, which allows you to take a deduction based on your mileage. For this deduction, you simply multiply the number of miles driven for business by the IRS’s standard reimbursement rate.”
“The truth is that the home office deduction has not been a high audit area
for over a decade. In fact, in recent years, the IRS has made it even easier to standardize ways this legitimate tax deduction can be taken.”
“If you work your day job from an office building and occasionally do work at home after hours, you may not qualify for the home office deduction. However, if you work from home most of the time, perhaps because you don’t have a separate office space, you may be able to take the tax deduction. You may also qualify for the deduction by working mostly from home and visiting the office only occasionally to meet with clients. Or perhaps you are a telecommuter and only visit the office for a monthly meeting or to check in with your supervisor.”
“Even though Ali’s main place of work for her engineering business was in an office, her home office was still her “primary place of business” for her real estate activities. Because she did not have another primary place to conduct her real estate business, she met the primary place of business requirement for her home office.”
“Secondly, the part of your home that you use as your home office must be used exclusively for business purposes.”
“Another common myth is that you have to have a net profit to take the deduction. In reality, it is sometimes possible to take a home office deduction even when there is no net profit on the tax return. Strategies using legal entities such as S corporations can help companies that are losing money still get a tax deduction for home office write-offs.”
“Some common expenses you can claim on your tax returns are mortgage interest, property tax, homeowners association dues, and homeowners insurance. In addition, the cost of cleaning, utilities, phone service, Internet, and even security or alarm systems may be partially deducted as part of home office expenses. Last but not least, maintenance, pest control, repair, and home improvement costs may also be used as write-offs for your business.”
“What most people do not know is that even if you do not own your home and are simply renting an apartment, you may still benefit from the home office write-off by deducting a portion of your rent and renter’s insurance.”
“For example, if you paid $10,000
in mortgage interest during the year and deducted $2,000 as a home office expense for your real estate business, only the remaining $8,000 can be reported as an itemized deduction on your personal taxes.”
“The new simplified method allows you to deduct $5 for each square foot of home office space. For example, if you use a 100-square-foot area of your spare room as your workspace, you may be able to take a $500 deduction. However, using the simplified method means that you generally cannot take any additional write-offs related to your home office, such as cleaning, repairs, or insurance. Property taxes and mortgage interest are still deductible on your personal tax return, so in a way, the simplified method allows you to double dip a little of your expenses.”
“This rule has limits, however, and there is a maximum deduction of $1,500, which corresponds to 300 square feet.”
“Although certain entities can provide some special tax write-offs, the truth is that more than 90% of the common real estate–related write-offs can be taken whether you have a legal entity or not.”
“It is important to note that we don’t recommend doing this very often, because you want to keep personal and business money separate; otherwise, this could affect your asset and audit protection. However, if you do accidentally use personal money to pay for a business expense, simply have the company reimburse you for that cost. This is a way to personally receive tax-free money from the business, while also creating tax deductions.”
“So with regard to creating entity structures, don’t put the cart before the horse. Make sure that you have real estate–related income before spending a ton of cash to form your legal entities.”
“Before forming any entity, be sure you understand what the annual maintenance costs will be each year. Take a cost-benefit view to determine which type of entity and how many make sense for your real estate portfolio. Before you pull the trigger, meet with your personal advisor to discuss where you invest, what you invest in, and how much profit you make so they can help you to develop the best entity structures for your specific situation.”
“By filling out a one-page Form 4506-T, Steve was easily able to request tax transcripts for all three years that were overdue. Once the IRS received this form, they mailed an account transcript showing what other people had reported under Steve’s name as income each year. For example, the amount of money his property management company collected was on this transcript, as were certain other items, such as mortgage interest paid to the bank.”
“Essentially, getting a copy of this tax transcript helped Steve ensure that his records matched what others had reported to the IRS. This is a quick and easy way to arrive at the main income amount without going through the bank statements in detail. The best part, believe it or not, is that the IRS will send you the transcript for free.”
“Simply contact the mortgage company to request a year-end 1098 Form, and this document will generally show the total annual mortgage interest, taxes, points, and insurance paid.”
“Security deposits are payments that you hold on to until the tenant moves out. Because this is money that you may be required to return to the tenant, this is not income for you in the year you receive it.”
“Whether you have a separate legal entity or not, one of the easiest ways to save a ton of time and headache with your bookkeeping is to have separate bank and credit card accounts for your real estate and personal items”
“However, when we worked with him on his tax planning, we noticed that his property management report was missing a few key items. For example, the management report did not include mortgage interest, property taxes, or insurance. All three of these expenses were paid directly by our client, so the property manager had never even seen these statements. After factoring in all these additional expenses, the net profit was really only $4,000 each month—not nearly as high as the owner initially thought.”
“In addition, rental property owners can often incur out-of-pocket expenses related to the property. These out-of-pocket expenses are also generally not included on a property management report, as the managers typically are not aware of them. Although property management reports do provide a good starting place for bookkeeping, you still need to make sure you understand what is and is not included in the report so you can calculate the true profit and loss on your rental.”
“Consider keeping a drawer or box of petty cash for minor day-to-day expenses. For example, if you have a petty cash box with $300, you can dip into it when you need to order lunch for your contractors or to buy that $25 gift card for your landscaper. Just remember to keep these receipts and record the expenses in QuickBooks.”
“For larger amounts, simply keep a copy of the receipt for the money you spent and then have the business account reimburse you. So if you spent $50 on paper and pens at Costco, simply have the business account write a $50 check to you personally. This way, you can record a $50 office supplies expense in QuickBooks to capture the write-off.”
“Your ability and willingness to keep your books up-to-date is the single most important element of effective bookkeeping.”
“More importantly, be sure to review your financials frequently to identify how your investments are performing and to gain better control over your cash flow.”
“For Roger, the best way to do this was to put $40,000 into his 401(k) plan to start. He could then take a $40,000 tax deduction, which would save him close to $13,000 in taxes he would have otherwise paid to the government. Instead, he had $40,000 in his retirement account that he could use to purchase a rental property. He could then let that property grow tax deferred over the next three decades.”
“The Solo 401(k), sometimes known as a Solo(k), is a more flexible and more powerful type of self-directed account. Using a Solo(k), Bob would be able to purchase a rental property using leverage without having to worry about UDFI taxes of 39.6%, regardless of how much debt he had on the property.”
“Self-directed retirement means you choose what you want to invest in; you do not select an option from a predetermined list of choices.”
“The IRS defines depreciation as ‘an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property.'”
“• Depreciation is taken each year that the property is actively in service as a rental.
• The same depreciation is taken whether the property value increases or decreases during the year.
• Depreciation is generally taken based on the purchase price of the property regardless of its current fair market value.
• Depreciation is calculated based on your total purchase price of the investment property,
regardless of what your down payment is.”
“First, you must own the property. If you are not the property owner and are simply renting from a landlord just to sublease a property out to someone else, you may not take depreciation on that property.
Second, the property must be an income-producing property. The most common example of this would be a piece of real estate that is generating rental income. Accordingly, there is generally no depreciation on your primary home or your second/vacation home if no income is generated from the property.”
“For example, if you install new carpet for $1,000 for your rental property, then you may be able to take a portion of the depreciation each year as a tax deduction. In five years, you would have taken a total accumulated depreciation of $1,000 based on the IRS depreciation table.”
“One of the pitfalls to watch out for when calculating depreciation for your rental property is to make sure that you break out your purchase price between land and building. Why is it important to split out land versus building? The reason is because although a building is depreciable under the tax code, land is not.”
“Another way to determine the land versus building breakout can be to contact the tax
assessor’s office for the county where the property is located. Many counties will have this information on their website readily available. Other times, you may even be able to find the land versus building value on your property tax bill.”
See also: https://budgeting.thenest.com/deduct-depreciation-own-home-rent-room-23498.html
See also: https://www.nolo.com/legal-encyclopedia/tax-issues-when-renting-out-room-your-house.html
“The reason that depreciation that has been taken on prior year tax returns increases your tax gain when the property is sold is because depreciation represents a portion of your purchase price that has already reduced your taxes.”
“A depreciation deduction is something that is required under the tax law. As indicated
above, the tax code provides very specific methods and timeframes for how each asset must be depreciated. This means that the choice to take a depreciation deduction or not is not at the discretion of the taxpayer.”
“In fact, what many investors may not know is that when you sell an investment property, the IRS will calculate your tax gain as if you took the necessary depreciation every single year. In our example above, if you were required to take $20,000 of depreciation over the years but simply chose not to, there could still potentially be a $20,000 tax gain when it comes time to sell that investment property.”
“If you are someone who has enough expenses to offset your rental income and do not need depreciation, take it anyway. In that scenario, the depreciation may create a net loss for your rentals, and that loss may be carried into future years to offset future rental income.”
“Accelerated depreciation is a powerful tool that can significantly reduce an investor’s tax liability. You will get the same amount of total depreciation expense over the entire life of the building, but now with a cost segregation study, you could get to deduct some of your purchase price a lot sooner! However, it may not be a great strategy for everyone. One potential downside is that cost segregation studies can be costly and time consuming.”
“Although Jane was right that she did not have to pay taxes on a gift she received, but that was not what we were talking about. We were referring to capital gains taxes. You see, if her dad simply gifted the property to Jane, she would receive her dad’s basis in the property. Because her dad purchased the property so long ago for only $56,000, he had written off most of the purchase price through his depreciation over the years. After looking at her dad’s old tax returns, we noticed that the remaining tax basis on the property was only $16,000. If this property were ‘gifted’ to Jane, her tax basis in the property would also be $16,000. If she were to sell this property down the road for $1.1M, though, she would have a gain of $1,084,000 that she would have to pay capital gains taxes on. This could end up costing her as much as $401,000 in taxes ($1.084M x ~37%).”
“On the other hand, if the property remained with her dad, and he kept it until he passed away, Jane could inherit the property and get a ‘basis step-up’ to the property’s fair market value. In this example, if the fair market value of the property at the time of her dad’s death was $1.1M, Jane’s tax basis would be $1.1M instead of $16,000. Using the inheritance strategy, if Jane decided to sell the property for $1.1M even just one day after inheriting it, she would pay zero taxes on that transaction.”
“With an irrevocable trust, her dad could move the property into the trust right away while maintaining certain rights. Upon his passing, the property could then be transferred from the trust to Jane, and she would get the step-up basis to fair market value on the date her dad passed away.”
“Capital losses are not like ordinary losses that you can use to offset your income without limitations. On the contrary, capital losses can only offset capital gains, and if there are excess losses, you can take only $3,000 each year on your tax return. The rest needs to be carried forward into future years.”
“Cancellation of Debt Income
$320,000 Debt Outstanding
($220,000) Fair Market Value
$100,000 Cancellation of Debt Income
The first step was to calculate how much of the $320,000 of discharged debt was actually taxable for Connie. The 1099 from the bank was inaccurate in showing that the entire outstanding debt amount was taxable. Although the outstanding loan balances totaled $320,000 just before the short sale, the entire amount was not taxable for Connie. The fair market value of the properties—which they actually sold for—can be used to reduce the taxable income. So in Connie’s case, only $100,000 of the $320,000 of 1099 income was taxable (i.e., only $100,000 of the loan balances were ‘forgiven’).”
“$220,000 Sales Price
($435,000) Cost Basis
($215,000) Ordinary Loss
As you can see, Connie had a loss of $215,000, according to this calculation. But here is where the capital loss mistake commonly occurs. Connie’s tax preparer, like quite a few others we’ve seen, treated this $215,000 as a capital loss instead of an ordinary loss. As a result, Connie was not able to use the loss to offset her cancellation of debt income.”
“The truth is that losses on rental properties are ordinary losses, not capital losses. Because the loss on the sale of rental properties is an ordinary loss, there is no limit to how much can be used each year to offset taxes. In Connie’s example, she was legitimately able to use her loss on the sale of the properties to offset the cancellation of debt income.
$100,000 Cancellation of Debt Income
($215,000) Ordinary Loss
($115,000) Net Ordinary Loss”
“The truth is that when you sell a property for a gain, it is indeed a capital gain, and you may be able to pay less tax using the lower tax rates. However, when you sell a rental property at a loss, the loss is actually considered an ordinary loss. An ordinary loss is better than a capital loss for two reasons:
1. With an ordinary loss, there is no annual limit on how much can be used to offset your income.
2. You can use an ordinary loss to offset your ordinary income, which is generally taxed at a higher rate.”
“If you sell a long-term rental for a gain, you pay less taxes at the long-term capital gains tax rates.
Conversely, if you sell a long-term rental at a loss, you get to pay fewer taxes because the losses are considered ordinary.”
“1. Fix and flip is generally considered active income and is subject to payroll or self-
employment taxes of up to 15%. Rentals, on the other hand, are never subject to this
additional tax.
2. Fix-and-flip properties are not eligible for capital gains tax and are instead taxed at the higher ordinary income tax rates.
3. Fix-and-flip properties are not generally eligible for long-term capital gains tax rates,
regardless of how long you own the flip property before selling it.
4. Fix-and-flip properties are generally treated as inventory and are not eligible for the same depreciation tax write-off as rental properties.
5. With a fix-and-flip property, you cannot write off the purchase price of the property until the year it is sold.”
“You see, in a fix-and-flip business, you generally cannot take a write-off for the purchase of a property until that property is sold.”
“If you have an active real estate business with a lot of losses, it may make sense to operate as a legal entity. Partnerships and S corporations are audited fifteen to seventeen times less often than are sole proprietorships, though no one knows for certain why this is. If we had to guess, we would say it’s because finding tax revenue with sole proprietors is easier for the IRS, because they are usually smaller or newer businesses, and a new business owner is more likely to have poor financial records or lost receipts than a large established business operating as a corporation or partnership would.”
“If the IRS processes a return for someone who earns $100,000 but spends
$120,000 on mortgage interest, that person would have a higher audit risk, because the system would flag that this person is living off more money than they are showing on their tax returns.”
“During an audit, the IRS will very likely want to see your bank statements. If you don’t have separate bank accounts for your personal and real estate activities, this can be problematic.”
“For example, if you traveled to Las Vegas to address some issues with your rental there, taking a picture of the broken lawn sprinkler you drove all the way out there to fix for is an effective way to show you were actually there.”
“Activity logs such as mileage logs, calendars, and phone records are also great documentation that can help you prove your case in an IRS audit.”
“If you do not have any investments yet, proactive planning may not be
for you. Do not spend all your money on accounting and legal fees until you are making money in real estate or business or from other investments.”
“If you do not have any money, then proactive planning is not for you.”
“This may be obvious, but if you do not have a tax liability, then proactive tax planing may not be for you.”
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