Tax season is right around the corner, and if you’re a new real estate investor the process can seem daunting. Documents, filings, accountants, forms, and maybe owing money—it can be an unsettling period for investors. At Stessa, we’ve teamed together with the experts over at The Real Estate CPA to discuss the top tax advice new investors ask us on a regular basis.
Here are the top 6 tax questions we mostly hear from up-and-coming real estate investors like yourself. This will help you prepare for tax time, and ultimately keep more of your hard-earned income.
How do I know if my rental property activity is passive or active?
In general, all rental property investment activities are by default considered passive activities.The only times your rental activities would be considered active is if you qualify as a real estate professional for tax purposes or provide “substantial services” (i.e. hotel-like services) to short-term rental guests.
Is the passive/active test applied any differently when the investment property is run as a short-term rental (STR)?
Yes, short-term rentals would be considered an active business if you provide “substantial services” to your guests. Substantial services include daily meals, daily cleaning or laundry, maid services, travel arrangements, vehicles such as cars or bikes, and other services commonly found in a hotel.Merely offering free use of your bikes and beach toys at a seaside rental would likely not be sufficient to qualify the real estate activity as active.
To be considered “substantial,” the services you provide must be in return for a “material part of the payments made by the tenant.” Based on examples from the IRS, this would amount to roughly 10-15% of the total rent paid by your guest.If you don’t provide substantial services then the STR activity is considered passive like most other rental property activities.
As a rental property owner, am I required to send vendors, handymen, and other service providers 1099s?
In general, landlords are exempt from filing 1099s.
That said, if you’re a real estate professional for tax purposes, provide substantial services to your short-term guests, or will be claiming the 20% pass-through deduction (199A), you’re required to file and send 1099s for any independent contractor you pay over $600 by January 31.
What are some key management strategies I can employ during the year to reduce my overall income tax burden?
The most impactful thing you can do is make sure you’re tracking all your expenses throughout the year. Stessa can help you stay on top of the data by automatically importing and categorizing expenses via a secure connection to your bank or property manager. When you accurately track income and expenses throughout the year, you’ll always have a good idea as to whether or not you’re likely to show taxable rental income for the year.
If you do, you can then make the decision to explore cost segregation studies to further reduce your tax liability. You’ll also want to make sure you’re classifying as many renovation or rehab costs as possible to repair and maintenance expense categories in order to reduce your tax liability to the furthest extent.
Are there common tax strategies or themes that you see time and again being deployed by your most successful clients?
The most successful investors find a way for either themselves or their spouse to qualify as a real estate professional while building a portfolio of multifamily properties. They then deploy cost segregation studies to generate large rental losses on paper through depreciation, which they can then use to offset the tax liability associated with their ordinary income.
This often allows them to simultaneously avoid paying taxes on their rental income and reduce or even eliminate, the taxes they would otherwise pay on their ordinary income from a W-2 job or unrelated business.
What are the most common misconceptions new rental property owners have when it comes to the tax implications of their investing activities?
Most rental owners fail to realize that they can’t take the losses from rental real estate against their ordinary income (i.e. W-2 or active business income) unless they are under the passive activity limits or qualify as a real estate professional.Even though they can’t typically deduct these losses against their ordinary income, rental property investors often end up paying little to no taxes on their rental income because of the depreciation expense.
So while they generally can’t use these losses in the way they imagined, they’re still sheltering their rental income from tax which is a major benefit of investing in real estate.
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