Real estate can be a profitable investment. But for some, it’s a career: you rent out or care for property as a business. If you’re a real estate professional, you know that tax planning can be confusing.
Figuring out whether you qualify as a real estate professional for tax purposes, understanding how to deduct depreciation, and knowing how to categorize repairs and improvements could save you money at tax time. A financial advisor could help with all of that, plus show you ways your individual business could pay less in taxes.
Are You a Real Estate Professional?
For tax purposes, you can be either a real estate investor or a real estate professional. An investor makes only passive income, and isn’t responsible for decisions about the property. For instance, if you own shares in a real estate company, but the company makes its decisions without you, you’re an investor. To be a real estate professional, work involving the property has to be at least half of the total work you do, and at least 750 hours annually.
Why bother qualifying as a professional? Real estate professionals benefit from a few tax advantages. For instance, investors are subject to a 3.8% net investment income tax (NIIT), while professionals are exempt. Also, passive losses are only deductible against other passive income. Real estate losses for professionals are considered active and thus deductible in more situations.
You don’t need to officially incorporate your real estate business to be a professional. You can have a sole proprietorship, LLC, corporation, or several other kinds of businesses. The size of your business, your desire to limit your liability, or your tax situation will determine what business structure is best for you.
The IRS does sometimes challenge this status, so if you call yourself a real estate professional, make sure you keep records of the time you spend working on your property business.
Real estate professionals can access all the tax advantages of other businesses, such as home office expenses, travel, and more. But did you know you also can deduct depreciation on your properties? Many people think of real estate as an asset that increases in value, but buildings do wear out. While the land your building is on doesn’t depreciate, the building itself has a useful life: 27.5 years for residential property and 39 years for commercial property. Every year, you can deduct one year’s worth of the building’s value, because the IRS assumes that the building has lost that much value each year. But make sure you find the actual value of the improvements and subtract the land value.
What if you don’t want to take the depreciation deduction? You should always take it, because the IRS will tax those deductions when you sell the property, using something called depreciation recapture. You will be taxed, at your usual rate, on a gain equaling 25% of the depreciations you should have written off—whether or not you actually remembered to do so! So don’t forget to take your depreciation deduction every year.
Repairs vs. Improvements
As a landlord or property owner, you’re constantly doing work on the properties you own. But does this work count as a repair or an improvement? Repairs are considered regular expenses (and thus deductible), while capital improvements can only be deducted as they depreciate, i.e., a percentage of the value each year.
How do you know which is which? Briefly, repairs keep the property’s value the same as before. For instance, you might replace a broken cupboard door or fix an oven that isn’t working. Improvements, on the other hand, add value or function that wasn’t there before. For instance, if you replace a broken refrigerator with a significantly better model, or buy a new HVAC system. To be sure the work qualifies as a repair rather than an improvement, you’ll need to meet a number of standards.
Deducting Your Losses
What if you lose money in your real estate business? In general, losses from rental property are considered passive losses. That means you can deduct them, but only from passive gains. If you don’t have any passive gains, you may be able to carry the loss forward and deduct them another year when you do have gains.
However, losses from rental property can be deducted normally in two cases. The first is when you are a real estate professional, as described above. The other is if your income is under $150,000 a year. In the latter case, you may deduct up to $25,000 a year in rental income losses if your income is under $100,000 a year. That allowance decreases between $100,000 and $150,000. To qualify, you must also make management decisions for the rental property and own at least 10% of it.
Real Estate Professionals Need Help With Tax Planning
As you can see, tax planning gets complicated when you’re running a rental or property management business. Decisions you make about property upgrades or the time you spend on your properties can drastically impact your taxes. You don’t want to find out at tax time that your lack of planning will cost you money.
Your best option is to find a financial advisor who knows the ins and outs of the real estate business and can help you maximize your deductions. Contact us to set up your first appointment.