(Disclaimer: The content of this article is not intended as financial or investment advice but rather information for educational purposes only.)
This article is based on the episode of the Building Equity podcast “Tax Strategies For Real Estate Investors” with BJ Cottrell from Cottrell Tax & Accounting LLC in Naples, Florida. Click here to watch the episode.
For individuals who are just starting their career in real estate investing, being proactive by speaking with a tax accountant initially can help ensure their record keeping is accurate and that they aren’t overpaying in some facets. Whether it is investing in an active rental property or a passive REIT (Real Estate Investment Trust), these types of investments are structured differently from a tax perspective than publicly traded stock, so it’s imperative investors get informed about the tax strategy that is best for their investment type to protect profits.
A new investor in the market could save thousands of dollars by hiring an accountant up front to overlook the proper tax planning strategy and help mitigate potential long-term losses.
Choosing the Right Tax Strategy for Your Real Estate Investment
Determining the best tax strategy for a real estate investor depends on the investment type. An experienced tax accountant would first need to understand the investor’s objective to advise accordingly. Common questions your tax accountant would want to know are:
1. What is the time frame for holding the property? This provides insight on potential capital gains and depreciation for deductions. Holding onto a property for at least a year can help mitigate taxes.
2. Is this a short-term rental or long-term rental? This prepares an investor for other taxes besides federal. For example, in the state of Florida, short term rentals (six months or less) must pay sales tax, which is 6%. The second tax that will have to be paid the tourist tax, which can be around 6-7%. Preparing for these taxes allows an investor to incorporate fees into the monthly invoice for their tenant, allocating funds for the investor to fulfill payments come tax time.
3. Is this a fix and flip? For investors who are engaging in fix and flips, their tax accountant will want to portray their real estate ventures as purely investments to alleviate Social Security and Medicare taxes and reap the benefits from the capital gains rates, depending on which bracket the investor falls under. If the IRS detects that an investor is engaging in fix and flips as a full-time venture, A.K.A “dealing,” investors can be hit with ordinary income tax as well as self-employment tax. To avoid being categorized as a “dealer,” it is recommended for an investor to have a job on a W2 and to never have more than one fix and flip property occurring at a time.
Whether an investor is buying and holding a property lot for a few years or owning several properties at a time, when it comes to the IRS, it’s recommended for an investor to be taxed at an individual level and pass-through to the personal tax return because of capital gains rates. Investors can take up to $25,000 of losses from a rental property to offset ordinary income on a personal tax return, which can’t be done with other passive investments because passive losses can only be offset by passive gains.
Another key factor when it comes to tax strategies is whether a business entity is involved. Whether it is an LLC, partnership, a corporation, or INC, each legal structure has a different designation on how they are taxed by the IRS. Most tax professionals and attorneys advocate for the LLCs because they’re more flexible and can be taxed as a single member LLC, which is disregarded if there’s two or more members; the default is to be a partnership, which is a pass-through entity. An S-corporation is also a pass-through entity as well, meaning the business does not pay income tax of its own; its income, losses, credits, and deductions all “pass-through” to each business owner’s personal tax return, where profits are taxed according to each owner’s individual income tax rate, giving investors the best tax treatment.
Make Depreciation Work in Your Tax Favor
One of the smartest ways real estate investors can keep more money in their pockets during tax time is taking advantage of depreciation. It’s common amongst hesitant investors when they hear about potential losses associated with depreciation to be discouraged about real estate investing all together. Understanding how to benefit from these referenced “losses” is how investors can get bigger deductions and maximize profits.
To fully grasp the concept of depreciation and how it can work for investors when it comes to taxes, let’s look at a hypothetical example:
– An investor buys a rental property for $275,000.
– The IRS requires the investor to depreciate the property every year for up to 27.5 years, which means every year, the investor takes a $10,000 deduction in depreciation.
– This depreciation goes on the investor’s tax return as an expense, reducing the basis. This allows the investor to write off $10,000 to offset rental income or even ordinary income from a W2 job because it is passing through to the individual tax return.
– Looking at the same investment in the long-term, if this same investor keeps this rental property for the next seven years, taking a $10,000 loss each year, and then goes to sell the property for $400,000, instead of a $125,000 gain, because the investor took $70,000 in expenses that went to ordinary income on the tax return, the investor will now have a $195,000 gain.
This example of depreciation shows how an investor with a rental property theoretically takes a loss on paper but capitalizes on cash flowing and building equity on the property. Because the intricacies of real estate can be extremely complex, to ensure you’re following the best tax strategy, it is critical to consult with a licensed tax accountant for proper guidance.
Pro Investor Tips for Bigger Tax Benefits
For investors looking to truly maximize deductions on their real estate properties each year, there are several recommendations to ensure optimal tax treatment:
Set Up a Business Entity- Creating a business entity for holding your real estate not only provides asset protection and limits liabilities but also lets investors run their rental properties like businesses, keeping personal and business funds separately. Whether it is a single member or a husband-and-wife single member LLC, or even a partnership depending on the circumstances, an investor forming an LLC receives an EIN number (a social security-type number for the business) and can open a separate bank account for the business. Having a separate account for the real estate business is crucial for investors because they can avoid comingling payments and expenses for tax purposes while also minimizing personal liability if a suit is ever filed against the LLC. It is also suggested to utilize this bank account or a single credit card for all property-related payments and expenses for complete transparency.
Investors who are looking to fix and flip multiple properties are strongly encouraged to set up an S-Corp (S corporation) to place all their real estate properties under. This type of business structure offers several tax benefits for investors, allowing them to write off all their expenses (cell phones, cars, computers, home interest, etc.). And while investors will be subjected to an ordinary tax rate as well as Social Security and Medicaid at a 15% self-employment tax, an S-Corp entity allows investors to pay themselves a salary while drastically reducing the amount of self-employment tax they will have to pay.
Save Receipts- Expenses related to properties add up over the course of the year, and if investors aren’t saving receipts or tracking their spending, they could miss opportunities for deductions on their taxes. The IRS will need to see verifiable proof of a business expense to claim a deduction, so saving receipts is vital.
Get Organized- Managing a real estate operation requires an organized system to run smoothly. Because running a real estate venture like a business is multi-faceted, investors need to keep track of their records, bookkeeping, expenses, and other documentation as efficiently as possible, especially when it comes time to extract this data for tax purposes. Software such a QuickBooks or even a simple Excel spreadsheet is highly recommended to ensure all your pertinent information is stored and easily legible.
Staying organized with your operation is essential, especially if the goal is to scale your rental business. Ambitious investors who are looking to expand their operations are highly encouraged to consult with a licensed tax accountant who can sign and assist with creating an official P&L (Profit and Loss Statement), which is a requirement if an investor wants to obtain a loan from a bank for further real estate ventures.
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