15 Ways Real Estate Investors Minimize Their Taxes-Part 1Financial Planning
BY CYNTHIA MEYER CFA®, CFP®, CHFC®
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What you will learn from this article:
Use a real estate savvy tax professional for tax planning and tax preparation
Understand the role of depreciation
Systematize real estate operations with a digital bookkeeping tool
Know when rental income is Qualified Business Income (QBI)
How real estate investors use the 1031 Like Kind exchange
Did you know that investing in real estate has attractive tax advantages? There are many ways real estate investments have favorable tax treatment in the U.S., including depreciation expense and tax-deferred like kind exchanges.
#1 Use a tax professional
A real estate savvy tax professional will help you optimize your tax situation (possibly saving you money), plan for complex events, and minimize tax-related frustration.
Proactive tax planning opportunities
Collaborate with your CPA or EA throughout the year. This is a foundational financial habit for real estate investors, and all other tax strategies flow from this one. As a CERTIFIED FINANCIAL PLANNER™ who works with real estate investors, I tell all my clients to use a knowledgeable tax professional for both tax planning and tax preparation.
Tax planning opportunities include:
- Purchases and sales of properties
- Timing of taking gains or losses
- 1031 exchange
- Syndication income
- Accelerated depreciation
- Qualified Business Income deduction
- Real estate professional status
- Vacation rentals
- Retirement plan contributions
- Pro forma return (a tax projection)
Find a real estate-savvy tax professional
You do not see many successful business owners preparing their own taxes or fully optimizing their tax situation without professional tax advice. Yet I have seen lots of DIY real estate investors do their own taxes. Find a great CPA or EA who has experience in real estate – preferably as an investor themselves.
Depreciation expense reduces a real estate investor’s taxable income. However, unlike the other property expenses, such as maintenance or taxes, depreciation is an expense on tax returns and financial statements only. In short: depreciation expenses are a deduction against real estate income, but not a deduction from the balance of your bank account.
Depreciation expense does not mean the value of the property has gone down. It means that the initial cost to purchase the property structure has been allocated as an expense against that asset’s income over time.
What is depreciation?
Property used in a trade or business, including a real estate business, wears out over time (“depreciates”) for tax purposes. The IRS allows taxpayers who own investment property to account for this cost by taking a deduction over time for depreciation of the structure – but not the land - on Schedule E Supplemental Income and Loss (See 2021 Schedule E).
It is hard to predict when an individual asset or property would get to the end of its useful business life, so the tax code sets standards. According to the IRS, residential property has a useful life of 27.5 years when calculating depreciation expense.
For 27.5 years, a rental property owner can deduct 1/ 27.5 of the rental property’s depreciable cost basis from their annual income from the property, until the property is fully depreciated. The depreciable cost basis is the purchase price of the property plus initial improvements, minus the initial value of the land. The IRS has plenty of rules and forms for figuring out the depreciable cost basis, so it is not quite as simple as it sounds.
How real estate can make money but generate tax losses
Net income from rental properties is taxable income to the investor. Due to depreciation expense, a rental property owner may have positive cash flow from the rental but show a net passive loss on their tax return. That would happen when the allowed depreciation expense for the property is greater than the gross rental income minus paid deductible expenses.
Depreciation expense effectively lowers the cost basis of your property over time. When you sell a property and gains or losses are recognized on your tax return, the depreciation expense claimed over the years is “recaptured” and taxed.
According to the IRS, “If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if otherwise nontaxable) as ordinary income.” Recaptured depreciation is taxed at the taxpayer’s ordinary income rate, capped at 25%.
Do I have to take depreciation expense?
Some DIY investors mistakenly believe that if they do not claim depreciation, it will not be recaptured when the property is sold. Be careful of this mistake. If the rental property owner does not take allowed depreciation expense, the IRS will still assume the taxpayer has taken it when the property is sold.
Does this talk of depreciation sound like an indecipherable language to you? That is one of the many reasons I encourage real estate investors use a professional tax advisor.
#3 Use a digital bookkeeping tool
Use a digital accounting tool to make tax time much easier. A good digital real estate tool will help you:
- Track rental income and expenses
- Link checking, credit, and security deposit accounts
- Track depreciation basis and expense
- Maintain records
- Produce financial statements on demand
- Determine profitability and financial ratios
Digital accounting tools for rental property owners
New investors may prefer an integrated, easy-to-use application such as Stessa, SparkRental or the Cozy tool on Apartments.com.
Those who already use Quickbooks for a business can learn how to use Quickbooks for their rental properties. If you are not already familiar with the tool, try an integrated application like those mentioned above. However, if you already using Quickbooks for another business, you may want to stay with one platform.
Investors with many properties, or property managers who are managing properties for others may opt to use a paid subscription to a professional real estate portal such as AppFolio, Buildium or Rentec.
#4 Know if QBI applies to your real estate business
Does rental real estate qualify for 20% qualified business income tax deduction (QBI)? It depends, so ask your professional tax advisor for guidance.
Part of the 2017 Tax Cuts and Jobs Act (TCJA), the 20% Qualified Business Income (QBI) deduction was created for tax fairness for smaller pass-through businesses (sole proprietorships, S-corps, partnerships) when the corporate tax rate was decreased.
Rental properties are typically considered passive investing activities that are not considered a qualified trade or business for QBI purposes. However, rental property activity that does qualify as a trade or business according to the IRS would be considered active businesses, with the possibility of qualifying for the QBI deduction.
Some taxpayers may qualify for the QBI deduction, but should always check with a tax professional:
- Real estate professionals, as defined by the IRS
- Other rental real estate enterprises that:
- Perform 250+ hours of rental services per year. This includes hours by employees, contractors, real estate agents, and property managers.
- Maintain separate books and records
- Keep a contemporaneous time log of real estate activities. That means you record details when you perform rental services, not at the end of the year.
Here is a good summary of the topic on TurboTax for understanding – but don’t let that be a substitute for professional tax advice on QBI. See also IRS guidance on Section 199A, Trade or Business Safe Harbor: Rental Property Activities.
QBI deductions are subject to IRS phaseouts
QBI deductions for all types of business income phase out on following total taxable income levels in 2021 (See IRS draft guidance for filing out form 8895): - Single filers $164,000 - Married Filing Jointly filers $329,900
Note that the QBI deduction itself is set to expire after 2025 unless it is renewed through legislation.
#5 1031 exchange
The 1031 exchange is part of an active real estate investor's tax planning toolbox. In our real estate business, we completed a 1031 exchange of a single family home for a duplex last year. Currently, we are in the process of exchanging a single family home into a small apartment building.
According to the IRS, "Whenever you sell a business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange."
The gain is tax-deferred (postponed) in a like-kind exchange under IRC Section 1031, but it is not tax-free. The adjusted basis of the property carries over to the replacement property. For more guidance, see IRS Like Kind Exchanges.
Characteristics of 1031 exchange
The replacement property must be for investment/business purposes, not for personal use. You cannot 1031 exchange your primary residence, or into a primary residence.
“Like-kind” generally refers to “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” For example, you could exchange a single-family home for a duplex, but not for a real estate mutual fund.
Replacement property should be of equal or greater value than the property that is sold. The amount of mortgage on the replacement property must also be the same or greater than the mortgage on the property being sold. Otherwise, the difference is treated as "boot" and is taxable.
Use a qualified intermediary to handle the transaction. If the taxpayer takes possession of the proceeds before the exchange is complete, the entire transaction could be disqualified and become immediately taxable.
The taxpayer(s) who own the original property must be the same as the taxpayer(s) who own the replacement property. This can get complicated when there are multiple property owners who do not agree on what to do next after a sale.
Time limits for 1031 exchange
There are strict time limits for a real property 1031 exchange:
- 45 days from the date you sell the relinquished property to identify potential replacement properties
- The replacement property must be received, and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
Misunderstandings about how a 1031 exchange works are common, so if you are considering this, do not DIY! Please get professional tax advice before you get started and to help with tax preparation for that year.
This blog is for general financial education purposes. Information contained in this blog should not be construed as financial, tax, real estate, legal or investment advice. For educational purposes, blog posts may contain links to other websites which are not under the control or and are not maintained by Real Life Planning. Real Life Planning has provided those links for your convenience but does not necessarily endorse all the material on those sites. Please consult your financial, real estate, legal, or tax advisor for advice specific to your situation.