Powerful Tax Planning Strategies for Real Estate Investors (Part 1)
Real estate investing is the number 1 way to build wealth in this country. It also offers many tax-saving opportunities that many investors are not aware of. Once you learn how to save hundreds, if not thousands off your tax bill, you will reap the rewards of your real estate investments much faster.
• Saving taxes accelerates wealth: Tax-free compounding means your earnings accumulate not only on the principal, but also on your tax-free earnings too. This means that compounding combines earning power on principal and earning power on interest. This is a definite advantage of real estate investing. For example, if you save $ 2,000 a year on your tax bill and invest it in an IRA on a 10% return, after 20 years you will have $ 114,000. You can also use your tax savings to improve your rental properties for more cash flow.
• Entity Structure: Select the right entity for your investments to protect your assets and support tax deductions which would be more aggressive if takes as a sole proprietor. With an entity, such as an LLC, you can use corporate documents to authorize and support deductions. This is documentation you need now that the IRS is hot on active participation for bypassing passive loss limitations, avoiding dealer status as well as deductions such as; auto, meals, entertainment and travel.
• Avoid IRS: There are many ways to audit proof your return from IRS intervention. Here are just two;
a) File an extension on your tax return. File as late as legally allowed. The IRS system of ‘first come, first serve’ tends to audit early filers more. To file extensions, use IRS forms 4868 for individuals and 7004 for entities like LLC’s and partnerships. You still have to pay your taxes on time, but this strategy reduces your chances of an audit.
b) Include written explanations and tax law citations to your tax return for items that will raise a red flag. For example for entertainment deductions and lots of travel, you could site IRS regulation 1.274-5T(c). You should also file related bills and receipts with notarized statements.
• Fire Bad CPAs: There are too many incompetent or overly conservative CPA’s working and they are largely responsible for ‘helping’ real estate investors pay too many taxes. You must ask yourself “whose side is your tax preparer on? Yours or the IRS?”. Here are some questions you can ask prospective tax advisors to weed out the duds:
a) Tell me some recent real estate tax changes that could help me?
b) Can you help me plan my taxes to ensure the best outcome in any scenario?
c) How will your reduce the chances of my return being audited?
d) Can you show me references from real estate investor clients?
Be sure to follow up on the references to find out how thorough, knowledgeable, helpful and accurate the tax preparer was with them. Don’t limit yourself to someone just because they’re local, today’s technology means everyone is open for business. You must search until you find a CPA who will put YOU first, be ethical, give you great advice and service and alert you to IRS tax traps.
• Don’t Overtax Rent Income: Rent income is not subject to self-employment (social security) taxes. Too many CPA’s classify rent income as self-employment income causing the investor to pay another 15% in taxes.
• Create Valuable Depreciation Deductions: This is your most valuable deduction because it does not require you to spend any cash to get the deduction. You also get the deduction every year, plus when you sell, you have no recapture and don’t have to pay any of these tax savings back by selling the property tax free via a 1031 exchange. You can extend these huge savings by componentizing:
a) 5 year Personal Property: Write off ‘hidden’ personal property over 5 years instead of 27 or 39 years. Examples include movable walls, kitchen cabinets, shelves, storage, carpeting and appliances.
b) 15 year land improvements – These can be written off over 15 years such as; landscaping, paved surfaces and parking lots
c) Land improvements to building – Examples include; outside lighting and utility connections
d) Low land value maximizes depreciation deductions – The land portion of the cost of property is not eligible for depreciation deductions. Allocations toward depreciable land improvements reduce amount allocated to non-depreciable land.
e) Fully deduct remaining basis of components that are replaced (rehab)
• Generate Repair Deductions: This where you want to use strategies to reclassify Rehab improvements into fully deductible repairs. There are many tax-saving benefits of classifying expenditures as repairs rather than capital improvements.
a) Componentize improvements: Separate invoices for each repair job
b) Documents should be worded as ‘repairs’. Certain words work in the taxpayer’s favor such as; patch, temporary, minor, annual and repaint.
• Get More Deductions: Always look for overlooked deductions to get more savings such as: home office expenses, business travel, entertainment
• Avoid Passive Loss Limitations: Deduct unlimited property tax losses even if they are over $ 25,000 or your income is over $ 150,000 as a real estate professional. Deductions can pile up so your properties will have paper tax losses which you want to fully deduct against your other income. Except for $ 25,000 of losses, rental property losses are subject to passive loss limitations.
This means real estate investors cannot deduct property tax losses against non-passive income such as salaries, business income, gains, IRA distributions, etc. To avoid this scenario, you must document at least 751 hours of time spent on the real estate property business. This will help you increase your cash flow each year.
• Avoid being a dealer: You must absolutely avoid the costly Dealer status. When you start doing real estate deals, the IRS may try to classify you as a dealer. This could be disastrous because you will be subject to the highest ordinary income tax rates plus social security taxes and alternative minimum taxes.
This means up to 50% of your hard earned money could disappear! Dealer profits also get taxed in full and cannot be tax-deferred. You can avoid this by by stating as an ‘investor’. There are many strategies to avoid the dealer status. One of the best is investment intent, which means to demonstrate the main purpose of quick sale profits is for investment purposes.
• Sell Your Properties Tax-Free: Avoid paying capital gains taxes on the sale of property. You can avoid the 25 – 30% on capital gains by:
a) 1031 Exchange: This is a ‘rollover’ of a like kind of properties that can avoid many tax liabilities. Examples include – rental houses, condos, duplexes and apartment building.
b) Reverse Exchanges – A way to bypass exchange deadlines and not rush into a bad deal. In a reverse exchange the closing is reversed so the replacement property is acquired before the closing of the relinquished property. This means you can do not have to rush when doing your deal and can look for below market bargains.
c) Self-Directed IRA – This is a great way to avoid taxes on gains, especially for quick flips. This strategy is recommended for real estate transactions that generate immediate income such as flips or options.
Here are some recent questions from my blog;
QUESTION: “I have the option to close at the end of December this year or begin of January. From a tax perspective what would you recommend? To note that I’m holding the property since August.”
ANSWER: It really depends on which year would be more favorable from a tax rate standpoint. Do you have other expenses this year that can offset the flip income? I usually advise my clients that these scenarios are best dealt with through a year end tax planning analysis. And there are Do it yourself kits out there as well as professional that can do this analysis for you to determine which one is better.
QUESTION: How are tax liens investments being taxed? I have bought the tax liens past summer. Most of them were redeemed within the first couple of months. On the rest I am hiring an attorney to proceed with the foreclosure. Anticipating they will get redeemed before the summer of next year (holding period is less than a year), am I going to pay a regular income tax rate on the collected interest? understand the tax liens are passive investments in nature, but I am not sure if the 12-months holding period applies to them.
ANSWER: It depends on what you get at the end. In your case, because they are redeemed, then all you have is interest income which is passive income. If the properties are not redeemed and you foreclose, then it depends on your investment intent at that time. If you hold the properties, then it’s passive but if your intent is to flip, then it is active subject to Self Employment Taxes.
Article courtesy of Al Aiello’s daughter – Janine Golini ISU 3144 S Uber St Philadelphia Pa 19145
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. You can get more information at Wealth Building Plan