Tax deductions are not the top priority for most real estate investors.
Your major challenges include selecting what property to purchase, obtaining financing, managing expenses, screening tenants, making repairs and deciding when to sell.
Tax deductions on rental properties can get a bit complicated, but if you have taken a loss on your property that exceeds the yearly rental revenue, it is well worth the time to make the appropriate deductions on Schedule E of your tax return.
If you have losses from more than one property, the income or loss from each of the properties is combined to determine a net income or loss for the year. Even if your income does surpass your expenses, you may still have a loss after you depreciate a portion of the cost of the property.
The following suggestions may help you benefit from tax deductions sometimes overlooked by real estate investors.
Real estate depreciation is an area ripe with opportunities to improve your after-tax cash flow.
If you take the easy path and simply divide the purchase price of a property between non-depreciable land and depreciable buildings, you will eventually secure all of your depreciation deductions. But it’s going to take a long time – 27 1/2 years for residential buildings and 39 years for commercial buildings.
Your better alternative may be to perform a cost segregation study. Many assets acquired as part of the building “package” may be eligible for accelerated depreciation over the first five to seven years of ownership.
Your tax deductions will not be greater over the life of the property, but you will receive the cash benefit of the deductions a lot sooner. For properties acquired in prior years, you can still complete a cost segregation study and “catch-up” previously underreported depreciation deductions.
Another meaningful source of tax deductions is to scrutinize any cash expenditures being capitalized. Repairs should be deducted currently, rather than capitalized. Review items that were capitalized in prior years to identify any that have been removed or abandoned. The undepreciated cost may qualify as a current tax deduction.
Passive activity limitation
Income received from rental real estate is considered “passive” income, meaning it is received on a regular basis without much effort required. Likewise, rental losses are considered passive losses, and they can be deducted only to offset passive income, according to U.S. tax laws. The excess passive losses you have over passive income are called “suspended losses” and cannot be deducted until you earn more passive income or sell the property.
The way around the passive loss rules is to become “active” in your real estate activities. But that may be easier said than done, especially if you have another job.
An activity is considered passive if you don’t “materially participate,” or work in it, typically for a minimum of 750 hours a year.
Real estate professionals – or their spouses – are exempt from the passive loss rules. To qualify, you or your spouse must spend more than half of your working time, at least 750 hours a year, materially participating in one or more real estate activities.
Another exception is for people whose modified adjusted gross income is $100,000 or less. They may deduct up to $25,000 in passive losses if they have “actively participated,” meaning they have made meaningful management decisions on the property and have more than a 10 percent ownership.
If you own multiple properties, you must materially participate in each rental property, unless you elect to treat all your properties together as a single activity for tax purposes.
Examine all of your personal expenditures for overlooked tax deductions.
Home Office Deduction If you work primarily from home, you could be entitled to a home office deduction. The hurdle here is a high one. You must have a space in your home dedicated exclusively to conducting your business activities and meet other tests, too. But if you qualify, some of the costs of maintaining your home may be tax deductible.
Hire Your Children Consider hiring your children to help with your real properties. Paying your children a fair compensation for chores like mowing lawns or cleaning empty apartments not only teaches responsibility, it saves taxes. And if your children put the money into an IRA, they will begin to learn about investments and retirement planning.
Vehicle Expenses If you drive to your rental property to deal with a tenant, keep a record of your travel. If you drive to the hardware store to pick up a replacement faucet and then drive to the rental property to install it, add that trip to your list. If you keep proper records, you can deduct either the actual cost of your business trips (gas, repairs, depreciation on the vehicle, etc.) or the per mile rate established by the IRS (currently 56 cents per mile).
Travel Expenses If you are planning a vacation around a business trip involving a meeting, a seminar, or visiting one of your rental properties, business expenses are tax deductible – but your trip must be “entirely business related,” according to the IRS. Airfare and hotel for the business portion of your trip are 100 percent deductible, and meals and entertainment are 50 percent deductible. But any hotel, meals or entertainment costs before or after the business activity are not deductible, including your spouse’s airfare.
Technology Expenses Items used for business such as a computer, a printer, office supplies and business publications can be deducted. Do not overlook the deduction for business calls made on your cellular or land-line telephones.
To stay within the law and avoid unwanted attention from the IRS, you need to properly document your travel and other business expenses. However, the federal income tax savings make it worth the effort.