We’ve covered the basics of taxes for real estate investing over the past month, including deductions, 1031 exchanges, business travel, and more. In fact, we even teamed up with the experts over at The Real Estate CPA to write a comprehensive tax guide for real estate investors. Now it’s time to delve into some more advanced strategies available to investors. These include:
- The importance of date placed in service
- Capital improvements vs repairs and maintenance expenses
- Ins and outs of depreciation
- Cost segregation and 100% bonus depreciation
- Passive losses, passive activity limits
- The real estate professional status
Let’s dive into some nitty gritty real estate tax strategies that will ensure you’re paying as little tax on your rental income as possible.
The importance of date placed in service
When you first purchase a rental property it will be considered “placed in service” on day one if there’s an existing tenant in the property. If there’s no existing tenant, then the property is assumed to be not yet in service.
To place a property into service, you must meet two requirements: (1) the property must be ready for use; and (2) the property must be available for use.Generally, your rental is ready for use when the city or locality of your rental property will conservatively issue a Certificate of Occupancy. The rental property is considered available for use once it’s advertised for rent.
Rental property investors will often purchase a property vacant and in need of significant renovations before it’s ready to rent. Any renovation costs incurred before you place the property in service must be capitalized and depreciated, generally over 27.5 years, regardless of whether or not they are actual capital improvements or simply repair and maintenance expenses.
The key point here is that costs that are capitalized and then depreciated are recovered over several years and then are subject to depreciation recapture (a 25% tax when you sell the property). Regular repair and maintenance expenses are fully deductible in the year incurred and are not subject to depreciation recapture.
The way to successfully manage this distinction from a tax perspective is to complete the minimum amount of work necessary to get the property ready for lease, then immediately advertise it for rent. As mentioned above, the definition of ready for lease will be determined by the building codes in your locality, but is typically when sheetrock is on the walls and the flooring is finished. In other words, if the property is habitable and no longer dangerous, it’s probably also ready for lease.
Once the property is in service you can finish the renovation and deduct some of the costs as repair and maintenance expenses in the current year. Other start up costs such as appliances, which are normally considered capital improvements, become deductible in the current year under the de minimis safe harbor provision of the tax code.
Note that some renovation costs will always be considered capital improvements regardless of whether or not a property has already been placed in service (e.g. replacing the entire roof).Examples of renovation items you want to complete before youplace the property in service:
- Fixing structural issues (e.g. cracks in the foundation)
- Replacing an entire roof, floor, bathroom, kitchen, or plumbing system
- Adding a deck or new HVAC system
Examples of renovation items you want to do after you place the property in service include:
- Installing appliances
- Replacing a doorknob or window
- Repairing an existing plumbing system
- Other minor repairs
As a best practice, you’ll want to get in the habit of itemizing your invoices so that you, or your accountant, can more easily categorize these items as repair and maintenance expenses or capital improvements. Itemized invoices are also helpful in determining whether expenses might qualify under one of the safe harbors mentioned in the next section or for 100% bonus depreciation.
Capital improvements vs repairs, and maintenance expenses
Once your property is in service, you’ll need to determine whether each repair and maintenance expense you incur should be classified as a regular expense or a capital improvement that must be capitalized and depreciated. Most rental property owners will prefer to have as many of these costs as possible classified as regular repair and maintenance expenses in order to maximize current year deductions and minimize depreciation recapture.
Next, we’ll examine the differences between these two classifications and explore some common examples of each. But before we do, we want to make you aware of three safe harbors that may prove useful in moving some expenses that would otherwise be classified as capital, into the regular expenses bucket:
- Safe Harbor for Small Taxpayers
- Routine Maintenance Safe Harbor
- De Minimis Safe Harbor
We won’t go into all the details of these three safe harbors here, but the IRS official guidance on these safe harbors is required reading for rental property owners that want to maximize their current year deductions. You’ll also learn quite a bit about how the IRS approaches capital improvements versus repairs & maintenance expenses.
Repairs and maintenance
Repairs and maintenance are generally one time expenses that are incurred to keep your property habitable and in proper working condition. Examples of common repair and maintenance expenses include but are not limited to:
- Fixing: an existing AC unit, a faucet or toilet, a few shingles on a roof, a cabinet door, a few planks or tiles on a floor, a broken pipe
- inspect, or clean part of the building structure and/or building system
- replace broken or worn out parts with comparable parts
A capital improvement is an addition or change that increases a property’s value, increases its useful life, or adapts it (or a component of the property) to new uses. These items fall under categories sometimes called betterments, restorations, and adaptations. Examples that constitute capital improvements include:
- Additions (e.g. additional room, deck, pool, etc.)
- Renovating an entire room (e.g. kitchen)
- Installing central air conditioning, new plumbing system, etc.
- Replacing 30% or more of a building component (i.e. roof, windows, floors, electrical system, HVAC, etc.)
Depreciation is one of the biggest and most important deductions for rental real estate investors because it reduces taxable income but not cash flow.
For many landlords, the most important part here will be determining a property’s depreciable basis. The goal is to allocate as much of the property’s purchase price to the building value as possible to maximize your depreciation expense since land is never depreciated. The portion allocated to the building will be depreciated over 27.5 years, per the IRS guidelines for residential income property.
While allocating 20% to land and 80% to the building is a common practice, under an audit you may have to substantiate why you chose these numbers. This is commonly done by finding the land versus building value on an appraisal or property tax card filed with the county. You can also use comparable land sales to make this determination or commission a cost segregation study or appraisal by a third-party professional. Should you decide to deviate from the county tax assessor’s land versus building value ratio, you’ll need to be prepared to support your determination in an audit with independent documentation prepared by a third-party professional.
Cost segregation studies and 100% bonus depreciation
In a cost segregation study, certain costs previously classified as 27.5 year property, are instead classified as personal property or land improvements, with a shorter 5, 7, or 15-year rate of depreciation that uses accelerated methods to increase your near-term deductions. It sounds complicated but most tax accountants and some software will do the math for you.
Generally between 20-30% of the property’s purchase price can be reclassified under these shorter class lives which can significantly increase a property’s depreciation expense. Thanks to The Tax Cuts and Jobs Act, 5, 7, and 15-year property is now eligible for 100% bonus depreciation, which means its entire cost can be written off in the first year of ownership.
A building with a value of $100,000 will typically have $3,636 in annual depreciation ($100,000/27.5). However, if you were to commission a cost segregation study and find that 20% of the building’s value can be reclassified as personal property or land improvements, you could then deduct $20,000 in 100% bonus depreciation, and enjoy another $2,909 in regular annual depreciation for a total depreciation deduction of $22,909 in the first year.
It’s important to note that cost segregation studies make the most sense for landlords who are considered real estate professionals for tax purposes or expect to come in under the passive loss limits discussed below.
Cost segregation studies may also be worth considering if you consistently have net income from passive activities or a capital gain from the sale of a rental, since losses generated by rental properties can generally offset other passive income or gain from the sale of rental property.
Passive losses, passive activity limits, and the real estate professional status
As a rental property owner it’s not uncommon for your properties to produce a net loss for tax purposes thanks to depreciation and other operating expenses. The treatment of these losses is often misunderstood by investors for various reasons, so we’ll spend some time here to clear up common misconceptions.
Losses from rental property are considered passive losses and can generally only offset passive income (i.e. income from other rental properties or another business in which you do not materially participate, not including investments). If these passive losses exceed your passive income, they are suspended and carried forward indefinitely until future years, when you either have passive income or sell a property at a gain.
This is good news because a net loss (for tax purposes) means you aren’t paying taxes on your rental income today, even if you have positive cash flow.
Generally, the only time passive losses will offset your ordinary income from a W-2 job or another trade or business is under one of the circumstances discussed below.
Passive activity limits
Under the passive activity limits you can deduct up to $25,000 in passive losses against your ordinary income (e.g. W-2 wages) if your modified adjusted gross income (MAGI) is $100,000 or less. This deduction phases out $1 for every $2 of MAGI above $100,000 until $150,000 when it is completely phased out. Note: these limits apply to both those filing single or married filing joint.
In addition, in order to take losses against your ordinary income, you must materially participate in the activity by meeting one of the following seven tests:
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Note: these are the same tests used to establish material participation as a real estate professional discussed below.
Your MAGI is $100,000 for the year and your rental properties produce a net loss of $30,000. As long as you materially participate in your rental activities you’ll be able to deduct $25,000 of this loss against your ordinary income. The remaining $5,000 will be carried forward. Lets say, however, your MAGI was $125,000. In this case you can only deduct $12,500 of the loss because each dollar over $100,000 reduced the amount you could deduct by $0.50. If your MAGI was over $150,000 then you can’t deduct any of these losses against your ordinary income and the entire $30,000 is carried forward.
The real estate professional status
The real estate professional status historically allowed real estate investors to take unlimited rental losses against their ordinary income. This has now been limited to $250,000 in losses if single (and $500,000 if married) under the excess business loss limits introduced by the Tax Cuts & Jobs Act.
In order to qualify as a real estate professional you must spend at least 750 hours in a real estate trade or business and more than half your total working hours must be in a real estate trade or business. Due to these requirements, many investors who work a full-time job or full-time in another business that is not real estate-related will have a hard time qualifying as a real estate professional.
That said, simply meeting the above requirements will not necessarily allow you to deduct your rental losses against your ordinary income. You must also materially participate in the rental activity using the same tests mentioned above, but is most commonly done by electing to aggregate all your rental properties as one activity and then working 500 or more hours in this single activity per year.
Note that if one spouse qualifies for the 750 hour test, both spouse’s time on the rental properties count towards material participation, and losses can then be taken against either spouse’s income. This is a great strategy for couples where one spouse works in a real estate trade or business, works only part-time, or not at all outside of your investment activitiesNote: In any year you elect to be treated as a real estate professional for tax purposes, you’ll need to keep a log of all hours worked within a real estate trade or business.
While reasonable efforts were taken to furnish accurate and up-to-date information, we do not warrant that the information contained in and made available through this article is 100% accurate, complete, and error-free. We assume no liability or responsibility for any errors or omissions in this article.