7 Tax Strategies for Real Estate InvestorsIncome Taxes
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You hear it all the time: real estate investing offers tax advantages unavailable to other kinds of investors.
And while this may be true, you can’t enjoy these tax advantages if you don’t know what they are.
Consider the seven tax strategies below for real estate investors.
1. Invest in Learning the Tax Code
For example, when you’ve built up hundreds of thousands of dollars of equity in your properties ten years from now and you want to 1031 exchange them into something else, the accuracy and decisions you made on your tax filings early on will impact how much basis you’ll have in your future properties.
Also, it’s important to understand the tax rules in the states in which you are investing. The last thing you want is a notice from another state’s pesky department of revenue because you didn’t dot some I or cross some T. It’s not cheap to get taxing authorities off your back once you’re in their sights.
2. Understand the Other State Tax Credit
As property values rise on the coasts, it’s not uncommon for many investors to invest in states other than where they live.
But sometimes there is confusion around whether, for example, a California resident who owns properties in Ohio will pay tax to California or to Ohio (or to both) on that income.
Well, the good news is that you likely won’t be double-taxed on your income.
Most states have what is known as an “Other State Tax Credit” that eliminates this double taxation.
In the example above, the California resident will pay tax to Ohio on their Ohio-sourced income but will receive an “Other State Tax Credit” in California for (generally) the amount of tax they payed to Ohio.
However, there are other states (for example, Virginia) for which a California resident would claim the Other State Tax Credit on their Virginia return rather than their California return.
And of course these are just examples from a California investor’s vantage point.
It’s important to understand these rules for your state and the state(s) in which you are investing to be make sure you are not getting double-taxed on your out-of-state income and that you are taking the Other State Tax Credit in the proper state so you avoid getting a “love letter” from the Department of Revenue in the mail.
3. Realize What You’re Getting Into if You Set Up an Entity
“To LLC or not to LLC. That is the question.”
I am not an attorney so cannot give professional advice regarding asset protection.
And even if I were an attorney, I would not give such advice in a blog post because whether or not you need an LLC or a corporation or a trust or some other asset protection structure depends very much on your own individual situation.
However, I will say that the minute you set up an LLC or some other entity, you bring on yourself additional costs, business filings, and tax filings not only in the state in which you formed the entity but also in every state in which you have registered your entity.
Also, some states, such as California, impose rather onerous taxes and fees on entities.
Let’s say you’re a California investor who sets up an LLC in Indiana to hold your Indiana properties.
If you do so much as pick up the phone to call your property manager on behalf of your LLC while living in California, the California Franchise Tax Board says that you have to register with the California Secretary of State, file the Limited Liability Company Return of Income annually with the California Franchise Tax Board, and pay the $800 minimum tax every year!
4. Make Absolutely Sure You Calculate Depreciation and Amortization Correctly
There is perhaps no calculation that I see novice real estate investors getting wrong as the depreciation and amortization calculations.
And getting these calculations right is extremely important because the IRS will tax you on your gain as though you calculated depreciation correctly, even if you don’t.
What Is Depreciation?
For many expenses you have as a real estate investor, you can deduct their cost in the tax year in which you incurred the expense. An example of this would be the utilities you pay for your tenants if they do not pay these expenses themselves.
Other costs, however, cannot be deducted in the same tax year as the cost was incurred. These costs have to be “capitalized” to the basis of your property, and you get a deduction for a little bit of the cost every year.
Depreciation is the name for this deduction.
There are other costs that have to be amortized. These are costs associated with intangible assets. For example, the fees you pay to obtain a loan are technically “intangible assets” that have to be recovered over the length of the loan.
Here are some tips on calculating depreciation and amortization correctly.
Get Your Land/Building Allocation Right
Whenever you purchase a property, the tax code says that you have to allocate what you paid for it (your “basis”) between land and building.
The difference is that you can take a depreciation deduction on the basis allocated to building but not for the basis allocated to land.
This being the case, most people want to allocate as much as possible to building and as little as possible to land so that they can get more depreciation deductions.
Now, the everyday way to allocate between land and building is to use the county assessor’s determination of land vs. improvements for property tax purposes.
However, there are other reasonable methods that can be employed in determining the land/building split, such as based on replacement value of your building (with the difference between your total basis and the replacement value being allocated to land).
The point is that you must allocate some reasonable amount to land, or you just may find the taxing authorities knocking on your door.
Now, residential real property is depreciated for regular tax purposes over 27.5 years. This means that if you purchased a property for $100,000 and allocate 80% of the basis to building and 20% to land, you have a depreciable basis of $80,000.
$80,000 over 27.5 years gives you a deduction of approximately $2,909 per year (the calculation is actually more complicated than this due to something called the “mid-month convention,” but we’ll just go with easy math for sake of example).
Of course, a $2,909 deduction every year isn’t bad.
But it could be better.
See, you can allocate a portion of your purchase price to assets that for tax purposes have a depreciation period of shorter than 27.5 years.
For example, appliances have a depreciation period of 5 years, and most landscaping has a depreciation period of 15 years.
And guess what? Thanks to the Tax Cuts & Jobs Act, you can take bonus depreciation on these shorter-lived assets now, meaning that you can write them off immediately rather than over time.
The method by which one determines the amounts to allocate to these shorter-period assets is known as cost segregation.
Now, because there are costs involved in a cost segregation study, it typically doesn’t make sense if you only have a few single-family rentals under your belt.
But if you are investing in larger properties (or possibly a portfolio of similar properties), a cost segregation study may make sense.
5. Track All of Your Expenses
If you have an entity set up, it is very important to not commingle personal and business expenses.
The obvious way to do this is to have a separate business bank account and business credit card through which you pay expenses for your rental property.
And even if you don’t have an entity set up, getting separate accounts for your rental still makes a lot of sense because doing so makes it much easier for you to track your rental-related expenses.
Having all of your expenses neatly organized in front of you to determine which are deductible and to what extent is the first step in maximizing your tax deductions.
6. Make Travel Plans Strategically to Maximize Your Deductions
Planning a trip across the country to check up on your rental properties and perhaps meet up with your lender and property manager?
I have good news for you. If you plan your trip right, you can get deductions all of your meals, lodging, and other travel expenses for every day of your trip — even if you weren’t working every day!
What About My Travel Expense I Incur Before Actually Buying a Property?
Now, I would be amiss to not mention three very important rules that folks who have yet to start their real estate business would do well to keep in mind:
- You can only deduct travel costs to an area once if you have already established a business, e.g. purchased a property, in that area.
- Travel costs incurred before establishing a business, e.g. purchasing a property, are capitalized to the basis of the property once you buy it.
- If you never establish a business, e.g. never purchase a property, in a given area, then travel costs to that area are simply personal expenses that you may neither deduct nor capitalize.
Note that the the rules are different for real estate professionals, who may deduct costs incurred to explore new markets.
7. Keep Excellent Records
If you haven’t invested in rental properties or owned a business before, then keeping good tax records may be new to you.
Why? Because previously, the only tax documents you needed were the ones someone else prepared for you.
Your employer provided your W-2, your bank provided your 1099-INT, and your brokerage company provided your year-end 1099-DIV and gain/loss statements.
But now you’re a landlord, and you’re responsible for keeping your own tax records organized.
In addition to making sure you keep a good set of books for your business, here are some other tips on keeping good tax records so that in case the IRS or state taxing authority comes knocking, you’ll be ready for ’em:
Understand that the burden of proof is on you to prove expenses are tax deductible.
Let’s say you take a business trip to visit your rental properties. If you’re ever audited, the burden of proof is on you to show that the purpose of the trip and your daily activities was business-related, not on the IRS to show that it wasn’t. So make sure you have your ducks in a row.
Hang on to your receipts.
Some taxpayers are under the impression that bank or credit card statements are enough in an audit.
The IRS will want to see receipts to see exactly what your money was spent on.
And thanks to technology, electronic receipts are fine. Just snap a pictures of your receipt with your smartphone every time you get one and then upload your receipts to a folder on your computer or to a file storage app.
Don’t be shy with your camera phone.
Receipts aren’t the only things you should be taking pictures of.
Remember, the more documentation you have to support a business expense, the better.
For example, when you go on that trip to visit your rental properties, take a few pictures of your rentals to prove that you were there and maybe a selfie or two with your property manager.
This will make it much easier for you to show that your trip’s purpose was business-related.
Keep a mileage log.
Just because your property is out of state doesn’t mean you can’t deduct some of the miles you put on your car!
Your mileage to the local real estate investment club is deductible.
Your mileage to the airport on your way to your trip to visit your rentals is deductible.
Your mileage to your attorney’s office when he consulted you about asset protection for your rental properties.
Also, keep in mind that you aren’t limited to taking the standard mileage deduction for your miles. You can also deduct actual automobile expenses to the extent your car was used for business (based, of course, on mileage). It’s up to you to figure out which one will give you the bigger deduction!
But whichever method you use to deduct automobile-related expenses, tracking your miles is key. It’s as simple as tracking all the trips you took for business in a spreadsheet and, with Google Maps’ help, calculating the distance driven.
Logan is a practicing CPA, Certified Student Loan Professional, and founder of Money Done Right, which he launched in July 2017. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.