As a real estate investor, one of the most important yet intimidating aspects of your business is understanding and managing your taxes. It is a real problem for the real estate investors. The tax code dealing with real estate is vast and complex, with endless nuances, deductions, provisions, and frequent changes that can trip up even seasoned professionals. Filing your taxes incorrectly could lead to costly penalties from the IRS or missing out on tax savings opportunities.
In this article, we will break down the complicated world of tax laws for real estate investors into easy-to-digest sections. By the end, you’ll have a solid working knowledge of the tax landscape and how to leverage the system to your advantage.
Understanding Basic Real Estate Tax Terminology
If you’re just getting started in real estate investing, the tax lingo can seem like a foreign language. But don’t worry—here is a translation of the most important terms:
This allows you to deduct a portion of the cost of eligible assets, such as buildings and equipment, over several years. You do this by claiming depreciation expenses on your tax return each year rather than deducting the entire cost in one year.
Common depreciation methods for real estate include straight-line and accelerated methods. This lowers your taxable income annually and is one of the most valuable tax deductions available to real estate investors.
Your basis represents your investment in the property. It generally includes the original purchase price plus any capital expenditures that improve the property. Keeping good basis records is important for calculating profit/loss on sale and depreciation amounts. The basis gets lowered annually by any depreciation taken. Understanding the basis is key to properly reporting taxes.
Costs that improve the overall property and not just maintain it can be added to your basis. This increases the potential for write-offs down the road. Common capital expenses include remodeling kitchens/baths, adding garages, new plumbing/electric, and repairs due to natural disasters.
Income from pass-through entities like partnerships, S corps, and LLCs is not taxed at the business entity level. Instead, the profits/losses pass through to be reported on the tax returns of the individual owners or partners. This lets small business owners like landlords benefit from business profits directly on their returns.
When you sell a depreciated property for a gain before fully depreciating, the depreciation previously claimed must be “recaptured” or added back and taxed as ordinary income instead of a long-term capital gain. Understanding recapture rules is key to proper tax implications of any property sale. Check out Depreciation Recapture
https://global.oup.com/us/companion.websites/9780190296902/sr/interactive/it/capital/ to learn more about recapturing an asset in real estate.
Determining Your Tax Filing Status
One of the first decisions to make is choosing your filing status. The four main options are:
Single—Use this if you’re unmarried or considered unmarried for tax purposes.
Married Filing Jointly—Husband and wife combine income/deductions. Often results in lower taxes than filing separately.
Married Filing Separately—Each spouse files their return using only their income/deductions.
Head of Household—For unmarried individuals who provide a home for a qualifying dependent.
Take time to evaluate your specific situation to determine the most advantageous status. Consult a real estate CPA if you have a complicated filing scenario. The choice you make here impacts deductions and your overall levied burden.
Report Income: Rent Received, Depreciation, Expenses
It’s time to tally up all the money coming in and going out of your real estate business. Rent received includes all rental income collected minus vacancies. Be sure to report any security deposits you kept too.
Claim annual depreciation deductions using the modified accelerated cost recovery system (MACRS) by taking depreciation on buildings over several years, and equipment over several years. Deduct operating expenses like repairs, property management fees, insurance, utilities paid, advertising, and travel. You can find out more about (MACRS) here.
Maximizing Deductions And Tax Credits
There are several common deductions and credits available to real estate investors. It’s important to take advantage of every legitimate one. Some of the big deductions include:
Mortgage interest—You can deduct interest on mortgage debt used to buy a property, up to a certain amount each year.
Property taxes—Taxes paid on an investment property are deductible both on your federal and state returns.
Rental losses—The rules let you use a portion of annual losses from rental real estate to offset other income like a salary.
Home upgrades —Look for tax credits for making energy-efficient improvements.
Opportunity Zones—By reinvesting capital gains in designated low-income areas, you can defer taxes on those gains for several years.
Be sure to have a property CPA review your situation each tax season. They can help identify any unused credits or deductions. AdviseRE offers services that help you save taxes using customized strategies. Don’t leave deductions on the table if you qualify—take full advantage of the tax code to save money.
Navigating real estate taxes certainly requires continuous education and effort. But as you can see, there are also significant financial benefits available if you make the time to understand the system.
Going forward, be sure to continue educating yourself on new property laws and strategies through industry publications, conferences, or a real estate CPA as staying current is important, and establish a yearly tax planning process where you review opportunities with your consultant.