The Definitive Tax Guide for Real Estate Investors
There are few investments out there as beneficial as residential or commercial real estate. Known for its tax advantages, income stream, and appreciation, investing in real estate can certainly be rewarding. Just about every expense that is associated with owning and managing real estate typically provides a tax benefit that is related to the rental income. In addition to the financial advantages of investing in real estate properties, investors also can benefit from tax laws at the back end and ownership of real estate can generate substantial tax savings, including tax sheltering.
When it comes to taxes, a real estate investor can have their hands full. In this definitive tax guide, we will provide you with the information you need to better understand the taxes associated with investing in a real estate property.
Legal Entity Structures
One common question that many real estate investors often wonder is what type of legal entity should they hold their real estate in. Of course, this can depend as there is no “one size fits all” investment strategy that works for every real estate investor out there. However, there are three types of entities that are most commonly used to invest in real estate: Limited Liability Company, S Corporation, and Limited Partnership. Let’s take a quick look at these different entities.
Limited Liability Company
A limited liability company, also known as an LLC, is typically the best entity for real estate and mortgage investors that follow a “buy and hold” strategy for their investments. When an investor buys and holds real estate property, it is considered a capital asset. In most states, including North and South Carolina, the ownership of real estate does not enact the transaction of business. This choice is typically the most beneficial for long-term investors.
Some real estate investors only invest in properties to flip them. Flipping properties has become quite the trend in recent years and is a great way for investors to profit. When a real estate investor invests in a property to flip it, they basically are following a “buy and sell” strategy with the goal of making a quick profit. When real estate properties are flipped, they then are considered an inventory and the investor is technically a dealer. However, a real estate dealer is vastly different from a real estate investor. For example, buy and hold investors have certain tax benefits available that dealers do not, such as:
- Capital gain tax rate
- Depreciation deductions
- Tax-free like-kind exchange under Code Section 1031
For real estate investors that flip properties, it is best to form an S Corporation, as this allows them to avoid self-employment or social security taxes on a portion of the profits received from flipping real estate. Careful consideration needs to be taken when considering any type of entity structure including this one.
Another entity that many real estate investors are interested in. To have a limited partnership, there must be one or more general and limited partners for the purpose of a business venture. Typically, the general partners are responsible for managing the investment while limited partners handle the capital invested into the partnership. One of the advantages of this entity ability to invest funds and let the general partner manage the everyday tasks associated with the operation. In addition to the limited liability and duties that investors have, there are also tax benefits, such being able to pass through tax losses, providing greater diversification, and allowing flexibility in allocating gains and loses amount partners.
In the unique situation that real estate investors plan to flip some properties and hold others for a longer term, they should consider forming at least one S corporation for flipping properties and at least one LLC to own property long term. Mixing real estate investment strategies in the same entity should never be done as it can lead to problems.
Professional CPAs can assist investors with setting these companies up. Contact your local CPA to learn more.
Passive vs. Active Real Estate Investing
Typically, investing in real estate takes two major forms; active and passive investments. Let’s take a look at the two forms of investments.
Active Investing – Active real estate investors typically purchase and manage properties for rental income or they will flip them to make a profit. These investors are typically involved in every step of the process, from selection to acquiring financing, to personally managing the investment. Active investors work hands-on and are actively involved in making their investment pay off.
Passive Investing – If you are a passive real estate investor, it is likely that you are not as involved with your assets as an active investor would be. There are several vehicles for passive real estate investing, most notably real estate investment trusts, or REITs. While passive investors are not 100 percent involved in every part of the deal, they still have to pay close attention and have a good understanding of what is going on with their investment.
Setting Up and Maintaining Accounting Records
For real estate investors, it is essential to keep track of your books and taxes for the properties that they own or manage. Maintaining records and books allows real estate investors to gain a better perspective on their investment and provides a basis for decision making. However, this can quickly become an overwhelming task when there are multiple properties involved in the mix. Investors can easily fall behind on monthly and quarterly accounting, expenses can slip through cracks, and estimated tax payments can not get made. Here are five tips for setting up and maintain accounting records.
- Have Separate Credit/Checking Accounts
Establishing separate accounts is the first step to implementing an effective system to maintain records and books. Maintaining quality accounting standards by maintaining separate bank accounts and only using business funds for business-related expenses will help real estate investors observe how their investment is performing which leads to better business decisions. It will also enable them to keep personal funds separate and it can create a personal budget, since investors will not be conflicting business and personal funds.
- Maintain Separate Business Credit Cards
Maintaining a separate business credit card allows real estate investors to build up a line of credit for their property investment. Any interest rate incurred on their card is deductible as a business expense. Keeping a separate business credit card from a personal one serves the same purpose and function as maintaining a separate bank account to properly track expenses.
- Track Expenses Correctly
It is important for investors to have a system in place for tracking certain expenses that overlap. These expenses can be related to personal car or home office usage, both of which can be documented, categorized, and expensed properly by real estate investors.
- Properly Categorize Expenses
Placing both business and personal expenses into the right categories can be a challenge for some real estate investors. The best bet is to consult with a local CPA to properly identify and sort the current expenses.
- Establish A Reasonable Personal Salary
Establishing a personal salary is critical when it comes to taxes. Real estate investors that set their salary too low can risk payment of unpaid employment taxes, hefty penalties, and interest. Establishing an annual salary that is too high will lead to overpayment for taxes. The best way to avoid these penalties is to consult with a tax professional that has real estate knowledge.
As an investors finances and portfolio grows, it makes sense for them to use automated accounting systems, such as Quickbooks or Xero. These online systems will increase an investors expenses, but it will save them time and from making costly mistakes.
When business expands, monthly expenses and revenue will continue to rise, making it indefensible to manage finances effectively using a spreadsheet. These systems enable an investor’s business bank accounts and credit cards to be linked in one central location. Additionally, each income and expense item is charted for specific income and expense categories to ensure the most accurate and advantageous tax position when filing.
Real estate investors face unique challenges and opportunities, and since a lot of the work that they do is conducted outside of an office environment, managing their expenses is very vital. Maintaining and tracking expenses and records properly will allow real estate investors to hold a consistent cash flow while maximizing tax deductions. By keeping a streamlined bookkeeping system, real estate investors can be more susceptible to significant tax savings.
What Can Be Deducted From Taxes?
One of the most attractive benefits to real estate investors comes in the form of deductions. When the time comes to file their annual tax income, real estate investors have the advantage of being able to deduct certain costs and expenses. Here’s a glance at some of the tax deductions that benefit real estate agents.
Repairs and Improvements
Before, real estate CPAs had no clear distinction between what constitutes as a capital improvement, and what constitutes as a repair expense. Both of these can be beneficial for real estate investors, but they do differentiate. Improvements differ from repairs in which they improve a property’s overall value. This could be roof replacement, installing a new kitchen, or expanding the property. In contrast, repairs are confined to work that keeps a property in a functional and efficient condition, such as repairing leaks or repainting the walls. Repairs can be written off immediately, similar as you would with other expenses. Improvements, on the other hand, have to be depreciated over the years if they add value to the property.
Other Applicable Expenses
There are several additional deductible expenses that would be a burden to miss come tax season. These deductions include expenses related to personal car and office usage, meals while on the job, marketing, supplies, and travel. There are plenty of other expenses that can be deducted, many of them being ones most real estate investors wouldn’t think of.
The IRS takes into account the possible wear-and-tear that a property is susceptible to as time passes — this is known as depreciation of an asset. For real estate investors that invest in a rental property, they can use the depreciation as an annual tax write-off, reducing their tax liability. Depreciation sounds all fair and well until you have to deal with recapture. Recapture occurs when a home investor sells their real estate investment with depreciation. In this case, the IRS will recapture the amount the investor has been receiving in depreciation.
In addition, cost segregation, a method for analyzing the components of an property and calculating depreciation on the individual components instead of the property as a whole. Using this method enables real estate investors to defer taxes, reduce their overall current tax burden, and free up capital by improving their current cash flow.
Real Estate Losses
In some cases, real estate investors will end up losing money on their investment properties. While losing money on an investment is usually a bad thing, in some cases those losses can be used to help you reduce an investors tax liability. Additionally, the losses can be taken as a deduction against financial gains and income. However, there is a $3,000 limitation.
Passive Activity Losses
A passive loss is a financial loss within a property investment in which the investor is not a material participant. These losses can stem from an investment in an real estate property. Typically, passive losses come from the following activities:
- Equipment leasing
- Rental real estate property
- Investment in which the investor has no material participation
- Limited partnerships
- Partnerships, S-Corporations, and limited liability companies in which the real estate investor is not involved, or there is no material participation
Real Estate Professional
Income and losses from investing in real estate or a rental property are a passive activity by definition, unless you are considered a real estate professional. There are tax benefits available for investors who can qualify with the IRS for real estate professional status. To be considered as a ‘professional’ for tax purposes, an investor — or taxpayer — or their spouse, must meet the standards of a two-part assessment. First, they must spend the majority of their time in real property businesses. Next, to be eligible as a professional they must spend 750 hours or more in the businesses and rentals in which they materially participates in. However, there are negative implications to being labeled as a real estate professional in the eyes of the IRS that are associated with the associated tax benefit. If you are defined as a real estate professional, the IRS will consider your short-term gains and income as everyday income. This income will be susceptible to self-employment tax. S-corporations can be incorporated into their real estate investment portfolio, to reduce the increased tax exposure for real estate investors that are considered real estate professionals. Real estate tax planning and expertise is essential in this area to achieve tax benefit, so it is best to consult with a real estate CPA.
Dealers Vs. Investors
A real estate dealer is a person who buys property and then sells as an ordinary course of business. Because a dealer profits from this type of action, the dealer is allowed to record the incoming cash as a gain or a loss of everyday income. In contrast, a real estate investor establishes a buy and hold method overtime in order to identify appreciation and value. Investment real estate is defined as a capital asset, therefore it proceeds from the inclination of a property is susceptible to capital gain taxes.
With a 10321 tax-deferred exchange, real estate investors can sell a property and purchase a like-kind property while deferring capital gains tax. This can only happen when the proceeds from the sold property are reinvested into another property or properties of like kind and equal or greater value within a certain time period. A 1031 Exchange enables the deferral of taxes, but only if the real estate investor satisfies numerous requirements and completes both a sale and purchase within 180 days. These like-kind exchange rules are a high priority for many real estate investors.
When real estate investors sell a property on the installment bias, typically a down payment is received with the balance of the purchase price paid in installments in consecutive years. Investors may choose to elect out of installment sales if the capital losses or suspended passive losses offset the tax gain on an installment sale. In order to qualify as an installment sale under certain tax law, the real estate investor selling the property must receive at least one payment within a year of the sale. While installment sales require investors to wait several years before receiving a sold properties entire market value, they can be very beneficial. The advantages of installment include tax deferrals, reduced tax liability, and long-term capital gains treatment. While installment sales are not the right strategy for every investor to follow, patient sellers are better equipped to finalize an agreement with their help.
Monetized installment plans
The IRS allows capital assets to be sold without the instant gain recognition through a monetization loan with an installment sale. This can be used as a strategy to defer taxable gain recognition. While a monetized installment sale strategy does not eliminate the capital gains tax, it does, however, defer the payment. A monetized installment sale can be a great way to defer taxes, but they generally require the assistance from a professional tax advisor’s in order to be effective.
Self Directed IRAs
Self-directed IRAs are alternative investments that are accepted or offered by the financial institution accountable for record keeping and IRS reporting requirements. Investors can use an IRA to invest in any real estate property, whether land, commercial properties, or residential rental properties. Real estate investors cannot pay any expenses directly from any other accounts; all repairs, property taxes, and other expenses must be funded from the IRA. Benefits of using self-directed IRAs include various tax advantages and enabling real estate investors to have complete control over what their money is invested in.
For many investors in this industry, real estate is responsible for the largest portion of their net worth. For both income and long-term appreciation, real estate has become a trendy investment tool. Investors interested in depriving in real estate have multiple options — such as a donation, bargain sale, retained life interest, or charitable remainder trust — that can potentially provide them with an income stream that may result in charitable tax deductions and the avoidance of capital gains tax.
Charitable Remainder Unitrusts
Charitable remainder unitrusts, or CRUTs, can be an effective tool for transforming real estate into higher income producing assets. With these trusts, investors have the opportunity to sell a
property, reinvest the proceeds into a diversified portfolio of securities, all while avoiding any capital gains tax liability. While charitable remainder trusts can be beneficial, they are more effective with assistance from an experienced real estate CPA.
Tax Law Changes in 2018
The new tax law changes this year can be overwhelming for real estate investors. To start, the tax brackets have changed and the standard deductions have increased. This means that a large number of investors will see a reduction in their owed taxes. Also, child tax credit has risen, and 529 Plans have evolved. Last year, taxpayers could be eligible to receive a tax credit of $1,000 per qualifying child. Now, that tax credit has doubled, giving the eligible taxpayers a tax credit of $2,000. Additionally, a refundable tax credit of $1,400 per qualifying child is also available for eligible taxpayers. Other changes include increased thresholds for alternative minimum tax, increased bonus depreciation, and new rates for c-corporation entities, as well as a pass-through deduction. Working with a CPA will ensure you adhere to all major tax changes in effect this year.
As you can see, there is a lot that goes into real estate taxes for investors. In order for real estate investors to keep as much of their hard earned money as possible from their investments, it is best to work with a CPA experienced in real estate tax planning. For more information about real estate taxes, contact the professional CPAs at Camuso CPA. To stay up to date on tax changes, be sure to sign up for our newsletter!