Time and time again, I see people asking tax questions and receiving conflicting answers. The confusion stems from our overwhelming tax code. Companies make billions of dollars helping you “simplify” your taxes with software and advice. One big box tax retailer is the top lobbyist for making the tax code more confusing so that you have a perpetual reason to buy their products.
Frankly, I wish the tax code was simple. People like you could focus purely on business productivity. People like me would have to start businesses that add real value to the world (rather than adding value in terms of tax savings). I feel this plays into why I produce so much free content. I really want to break the tax code down for you as much as possible.
Today, I’m going to dispel tax myths related to real estate investors. I hope that you’ll find clarity with commonly debated tax items.
7 Common Myths About Rental Property Taxation—Dispelled
Myth #1: You must have a license to be a real estate professional.
This is a common question I see pop up over and over. Real estate investors believe that in order to qualify as a real estate professional, they must first obtain their real estate license.
In order to put “real estate professional” on LinkedIn, you may indeed need your real estate license. But to qualify for the real estate professional tax status, all you need is time.
For those that don’t know, qualifying as a real estate professional for tax purposes allows you to deduct passive losses generated from your rental activities that would have otherwise been suspended. For all my high earners out there, you know the pain of not being able to claim your suspended passive losses. The real estate professional status helps you get around that annoyance.
The rules are simple: Work 750 hours in a real estate capacity, and more than half of your time must be in real estate. You do not have to work on your rentals in order to hit the 750 hour requirement. You can be a full-time real estate agent, property manager, contractor, etc. and meet the 750-hour rule. However, you cannot have a full-time job unrelated to real estate and qualify as a real estate professional due to the “more than half your time” rule.
Those are all the requirements you need to qualify as a real estate professional for tax purposes. This is an annual election, so on January 1, your prior year hours are wiped out and you need to start fresh.
But here’s the catch. Once you qualify as a real estate professional, you must then demonstrate that you materially participated in your rental real estate activity. There are seven tests for material participation; the most common is the 500-hour rule. So aim for spending at least 500 hours on your rental real estate if you want to take passive losses that would have otherwise been suspended.
The key is to log and record your time as it relates to real estate. What type of activities should be recorded? I dive into that here.
Myth #2: If you have passive losses from rental real estate and cannot take them, you lose tax benefits.
I get emails all the time from clients and non-clients questioning the true benefit of rental real estate if you can’t take the losses.
The good news is that if your rental shows a passive loss, you aren’t paying taxes on the rental income being generated. Hopefully, you actually made money and the passive loss is just a “tax loss” rather than a hard loss. If that’s the case, pat yourself on the back. You’re reducing your effective tax rate slowly but surely.
When you have a passive loss from your rental activities and cannot use the loss due to high income, what happens to those losses? They become suspended until they can be used to offset future passive income or offset the gain on sale of an investment property.
You do not lose the tax benefits. The key is that you lose the tax benefits today, but those tax benefits will be used at some point in the future when the suspended loss is released.
Because you can use the suspended loss at some point in the future, we want to continue aggressively writing off everything that we legally can. Oftentimes I hear that people stopped writing off travel, transportation, meals, and home office just because they thought there were no tax benefits in doing so. Again, there are no tax benefits today, but you will reap the tax benefits in the future.
Oh, and you can and should always write off depreciation. It will increase your suspended passive losses that are being carried forward, but if you don’t write off depreciation, you will be in a ton of pain when you go to sell the property. Trust me on this.
Myth #3: Flipping income qualifies as capital gain.
Sorry, Charlie. This is the most painful news to break to eager tax savers.
Your flipping income will rarely be considered capital gain income regardless of how long you hold the property. The reason is you had intent to develop and sell the property—not develop, hold, and rent the property.
For folks wishing to achieve tax savings by qualifying their flipping income as long-term capital gain, you need to finish your rehab and then rent the property out for a period of time. Only then will you be able to justify the intent to hold the property for investment purposes.
If your CPA is writing your flips off as long-term capital gain income, give me a call when you get audited.
Myth #4: Short-term rentals are reported on Schedule E.
This is false (most times).
Regular rentals are reported on Schedule E, as they should be. However, short-term rentals will generally be reported on Schedule C like an ordinary business would be.
The reason is related to the transient basis rules. If a rental unit has an average rental period of seven days or less, it is considered transient. If the rental unit has an average rental period between 7 and 30 days and substantial services are provided, that rental unit is transient.
If less than 80% of your gross rents on a property come from long-term tenants, you have a non-residential rental property.
So, if you have a vacation home and all tenants stay on average for seven days, then 100% of your rental income is coming from short-term tenants. Thus, you have a non-residential rental property.
On the flip side, let’s say you have a multifamily property where you generate $80,000 from long-term tenants and $20,000 from short-term tenants. Here, you meet the 80% test, so you have a residential rental property.
The difference between residential and non-residential is key. Residential rental property is reported on Schedule E. Non-residential rental property is reported on Schedule C.
Schedule C subjects your income to self-employment taxes. Yikes! Here is more information on reporting your short-term rental.
I rarely include citations in my blog posts, as I try to keep them as non-technical as possible. However, if you (or your CPA) would like to see references, connect with me and I’ll show you what you don’t want to see!
Myth #5: You can deduct costs incurred to rehab your rental units.
I always hate to be the bearer of bad news here, especially when it’s a client that we failed to inform.
You cannot deduct any costs incurred on your rental property until you place the property into service. Without placing the property into service, we are forced to capitalize costs and depreciate, generally over 27.5 years. Placing the property into service means advertising the property for rent.
The one exception to this rule is if you already own rentals in the same geographic location as the new rental you are rehabbing. You are then considered to already be operating in that general location, and thus you have flexibility in deducting your rehab costs rather than capitalizing without having to advertise the new property first.
Please folks, only listen to your qualified professionals on this matter. Do not trust the word of property managers, real estate agents, contractors, etc. Have your facts analyzed by a tax professional prior to engaging in any tax reduction strategy.
The benefit of placing the property into service prior to engaging in a rehab is profound. Doing so will allow us the flexibility to deduct costs as operating costs (if they qualify) rather than being forced to capitalize and depreciate the costs.
Capitalizing and depreciating the costs forces us to write off the costs over 27.5 years. Everyone should be able to understand that writing off costs today is much better than over 27.5 years.
But there’s a hidden benefit—writing off costs today rather than capitalizing and depreciating costs saves us money when we sell the property.
When you sell a rental property, you must pay “deprecation recapture” taxes generally equal to 25% of all the depreciation you’ve taken over the years. By capitalizing and depreciating our rehab costs, not only are we writing the costs off over a long period of time, but we must then pay a 25% tax on the depreciation amount that we have taken when we sell! Argh!
There are nuances to when you are allowed to advertise the property for rent. The property needs to be “substantially” complete, so we can’t advertise a shell for rent and think that all rehab costs will be deducted.
But we can definitely advertise the property for rent prior to painting—prior to appliances and granite countertops, prior to fixtures and lights.
Our clients tend to be surprised when we tell them, “Don’t rehab your property without letting us know the plan first.” But the reason for our request is simple: smart planning = tax savings.
Myth #6: Using 529 plans is great for real estate investors.
I received negative comments from people in the finance industry (surprise, surprise) and from folks who likely didn’t understand the strategy I was trying to demonstrate.
In fact, 529 plans are good investment vehicles for folks who want to save for college but do not own investment real estate or a business. Contributions to a 529 plan are generally deductible on the state level and never deductible on the federal level.
The problem is twofold: They stink in terms of tax minimization, and you can generally only withdraw funds for qualified education expenses without paying penalties.
I like flexibility. The 529 is inflexible. Thus, I advocate against the 529 plan.
Instead, we advocate for the use of Roth IRAs for college savings vehicles. You are able to withdraw Roth IRA contributions tax-free and penalty-free at any time. We don’t have to use the monies for a specific purpose, and we don’t get penalized if we choose to move the funds elsewhere. That’s flexibility.
A note on retirement plans: I am not advocating that you should tap into retirement plans. I am showing you a way that you can build wealth for your child and save for college while maintaining flexibility. This is also an “either/or” scenario—with the 529 or the Roth IRA. If you have the funds to contribute to a 529 and run the Roth IRA strategy I’m about to disclose, then use the 529 for college savings and the Roth IRA for your child’s future retirement. Otherwise, use the Roth IRA for college savings.
Here’s the strategy:
Hire your child to work in your business or on your investment portfolio. Pay them less than or equal to the standard deduction (currently $6,350). Transfer up to $5,500 of that payment into a Roth IRA in the child’s name.
You get a tax deduction for the payment to your child much like you would if you were to pay a contractor. Your child pays $0 taxes on the payment because children have a FICA exemption, and if someone earns less than the standard deduction, they don’t have to file a tax return.
So, you’ve literally created a tax-free transaction by moving money to your child. Additionally, your family wealth increased via your tax savings on the deduction you receive for paying for services/labor.
On top of that, we now have the funds in a tax advantageous vehicle, the Roth IRA. You know that you can withdraw the contributions tax-free and penalty-free. So, now you have a college savings fund, and should the child choose not to go to college, you have a house fund, wedding fund, retirement fund, or whatever else you want to call it.
But overall, you have flexibility, and to me, that’s priceless.
Myth #7: Following the BRRRR(RRR?) strategy allows me to refinance my property and continue to deduct mortgage interest.
The much-talked-about buy-rehab-rent-refinance-repeat (BRRRR) method is great for wealth building. It’s not great for taxes unless you have another property readily available to move the refinanced funds into.
When you refinance a property and take cash out, we must “trace” the cash to see where it is applied. When you let it sit in your bank account or if you buy some sort of personal item with the cash, the interest applicable to that cash becomes non-deductible from a tax perspective. We can only deduct interest on refinanced cash when it is applied to a rental or business activity.
So, you have a $100,000 home with $40,000 in equity. You find a lender who will lend 80%, so you lock that note up, leaving you with $20,000 in equity and $20,000 in cash.
The interest on the $20,000 in cash is non-deductible until you apply it to a rental property or a business activity. Please make sure you plan for this; otherwise, you’re missing out on easy money.