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:
- Painting
- 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.
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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:
- Painting
- Fixing: an existing AC unit,a faucet or toilet, afew 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
Capital improvements
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.)
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Depreciation
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.
Example
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.
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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.
Example
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.
FAQs
What are the 3 most important factors in real estate? ›
The three most important factors when buying a home are location, location, and location.
Can you deduct selling costs from capital gains? ›You are allowed to deduct from the sales price almost any type of selling expenses, provided that they don't physically affect the property. Such expenses may include: advertising. appraisal fees.
What does ESG stand for in real estate? ›Environmental, Social and Governance (ESG) as a value driver for real estate. “ESG”, the generally used acronym for “Environmental, Social and Governance”, has become an important business consideration all around the world. For instance, real estate investors have an increasing focus on sustainability.
Why stocks are better than real estate? ›The Advantage of Stocks
Stocks are very liquid, quick and easy to sell. They are also flexible, and can even be reallocated into a retirement account—tax-free—until you start to withdraw the money. Also, many stocks can do considerably better than real estate in one year.
C The four basic forces that affect real property values are social trends, economic circumstances, governmental controls and regulations, and environmental conditions. They are all interactive and affect all parcels of land. 1. Social forces are related to population characteristics.
What is the 5 rule in real estate investing? ›The rule states that a homeowner should expect to spend, on average, around 5% of the value of the home (per year), on the costs we mentioned above. Here's how it should go (in an ideal world): Property taxes should not amount to more than 1% of the value of the home.
How does IRS verify cost basis? ›Preferred Records for Tax Basis
According to the IRS, taxpayers need to keep records that show the tax basis of an investment. For stocks, bonds and mutual funds, records that show the purchase price, sales price and amount of commissions help prove the tax basis.
If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.
What home improvements can you deduct from capital gains? ›Some examples of improvements that increase your basis include installing wall-to-wall carpeting, central air systems, built-in appliances, a new roof, and storm doors and windows. IRS Publication 523, Selling Your Home, provides a list of the types of improvements that can be added to basis.
What does PRI stand for in real estate? ›PRI stands for Property Reserve Inc. (also Primary Rate Interface and 371 more)
Why does ESG matter in real estate? ›
ESG matters for real estate investors as buildings are responsible for 40% of the world's carbon emissions, use 40% of the world's energy and consume 30% of world's available drinking water. Fundamentally, for the real estate industry, ESG is a tool to assess, measure and manage risk.
What is ESG and what are its primary tenants? ›ESG means using Environmental, Social and Governance factors to evaluate companies and countries on how far advanced they are with sustainability. Once enough data has been acquired on these three metrics, they can be integrated into the investment process when deciding what equities or bonds to buy.
What is a better investment than real estate? ›Historically, the stock market experiences higher growth than the real estate market, making it a better way to grow your money. Stocks are more volatile than housing, making real estate a safer investment. Stock earnings are taxed as capital gains when realized. Stocks have no tangible value, whereas real estate does.
Can real estate make you a millionaire? ›About 90% of the world's millionaires over the last 2 centuries have come from real estate. So that's a resounding yes! For many investors, real estate offers a great opportunity to build wealth and create a large profit on each deal.
What is the average return on real estate investment? ›Residential properties have an average annual return of 10.6 percent, commercial properties have a 9.5 percent average return, and REITs have an 11.8 percent average return. Knowing the national average return on an investment property is extremely useful for comparing your return on investment properties.
What determines property value? ›Your home value is based on what willing buyers in the market will pay for your home, but every buyer is different. For example, one family might weigh location factors like schools and jobs over the size and condition of the home.
What makes a property more valuable? ›You'll usually find that the more desirable an area is, the more valuable your property is likely to be. Factors such as an area's transport links, parks, schools, shops and restaurants can improve the value of your home as the close proximity of these amenities can make a property more appealing and desirable.
What makes a property value go up? ›Simply put, as the housing supply decreases, creating an inventory shortage, home values go up. A real estate inventory shortage means that there are fewer sellers than there are buyers. Complicating matters, there is also a shortage of the building materials and skilled labor necessary to build new homes.
What is the 10% rule in real estate? ›A good rule is that a 1% increase in interest rates will equal 10% less you are able to borrow but still keep your same monthly payment. It's said that when interest rates climb, every 1% increase in rate will decrease your buying power by 10%. The higher the interest rate, the higher your monthly payment.
What is the 2% rule? ›The 2% rule is an investing strategy where an investor risks no more than 2% of their available capital on any single trade. To apply the 2% rule, an investor must first determine their available capital, taking into account any future fees or commissions that may arise from trading.
What is the most conservative private real estate strategy? ›
Private real estate funds generally use one of the following three investment strategies: Core-Plus, Value Added or Opportunistic. Core-plus. This is generally considered the most conservative strategy, characterized by lower risk and lower return potential.
What happens when you don't know cost basis? ›For noncovered securities, you are responsible for reporting cost basis information to the IRS when you file your taxes. If you do not report your cost basis to the IRS, the IRS considers your securities to have been sold at a 100% capital gain, which can result in a higher tax liability.
What can be added to the cost basis of property? ›Common improvements that might increase your cost basis include (but are not limited to) bathroom or kitchen upgrades, home additions, new roofing, the addition of a fence or desk, and various landscaping enhancements.
What is not added to basis of the property? ›Your basis includes the settlement fees and closing costs for buying property. You can't include in your basis the fees and costs for getting a loan on property. A fee for buying property is a cost that must be paid even if you bought the property for cash.
Do you pay capital gains after age 65? ›Does Age Affect Capital Gains Taxes? Currently, everyone has to pay capital gains taxes on property sales regardless of their age.
At what age is there no capital gains tax? ›Currently there are no other age-related exemptions in the tax code. In the late 20th Century the IRS allowed people over the age of 55 to take a special exemption on capital gains taxes when they sold a home.
What qualifies for lifetime capital gains exemption? ›When you make a profit from selling a small business, a farm property or a fishing property, the lifetime capital gains exemption (LCGE) could spare you from paying taxes on all or part of the profit you've earned.
How do you prove home improvements without receipts? ›A: You can deduct any home improvements that you can prove. You don't necessarily need receipts; photos, contracts, statements from contractors, or affidavits from neighbors, may be enough to convince the IRS that you actually did work.
Do new appliances count as capital improvements? ›The IRS distinguishes between a capital improvement and a repair or replacement due to normal wear and tear. For example, if your refrigerator breaks after several years of service, or you have leaky pipes, those repairs are not capital improvements.
Can I write off kitchen remodel? ›Can a Kitchen Remodel Count for a Tax Deduction? The short answer is that a kitchen remodel is potentially a tax-deductible expense in some situations. Yes, that means that brilliant cabinet refinishing, a plan to upgrade cabinets and other house renovation plans can actually help you to owe less in taxes for the year.
What does wid stand for? ›
| Acronym | Definition |
|---|---|
| WID | Women In Defense |
| WID | When It's Done |
| WID | Waste Incineration Directive (European legislation) |
| WID | Women and International Development |
The Press Trust of India Ltd., commonly known as PTI, is the largest news agency in India.
What does PIR stand for? ›(Passive InfraRed sensor) A device used to detect motion by receiving infrared radiation.
What is sustainable real estate? ›According to the online definition Sustainable real estate development is the practice of incorporating environmentally-friendly design techniques, materials and technologies into the building process.
What is ESG in property management? ›ESG – environmental, social and governance – describes a responsible, sustainable and ethical approach to investing in and managing real estate. Previously an optional approach to investing and managing property, it is now a central requirement. We believe it is possible to do what's right and achieve returns.
Why does ESG matter to investors? ›The advantages of proactively tackling ESG issues go beyond appeasing institutional shareholders and creating a good public relations story. A robust ESG program can open up access to large pools of capital, build a stronger corporate brand and promote sustainable long-term growth benefiting companies and investors.
What are the 3 essential pillars of ESG? ›The 3 Pillars of ESG. Successful businesses focus on three core essentials: people, process, and product.
What's a good ESG score? ›Some ESG ratings (or ESG scores) methodologies give a range from 0-100, with 70 and above considered a “good” ESG rating and 50 and below considered a “bad” rating. But others use a letter-based scoring mechanism—C (or CCC) being the worst and AAA being the best.
What is my personal ESG score? ›What is the score? An ESG “score” is set on a scale from 0-100, in comparison with a company's industry peers. If you score a zero, then you have a bit of work to do. If you score 100 (as if), it is more likely that you need to reassess your scoring system.
What happens to real estate when the stock market crashes? ›When the stock market retreats and the value of portfolios declines, investors are impacted psychologically.” If buyers start holding on to their money, then sellers will either have to pull their homes from the market or start settling for less.
What is a disadvantage of investing in real estate? ›
Real estate investments tend to have high transactional costs, especially in legal and brokerage fees. The process of acquiring a new property is also very long and tedious with lots of legal formalities. Another disadvantage of property investments is that they are not easy to liquidate.
Are REITs better than owning real estate? ›REIT Pros. Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit.
Who is the richest person in real estate? ›Li Ka-shing topped the list as the world's richest real estate entrepreneur at 94 years old with $33 billion, followed by Lee Shau-kee of Henderson Land with $27 billion, and Country Garden's Yang Huiyan of $26 billion, according to the Hurun Research Institute.
What is the fastest way to make money in real estate? ›- 7 Fastest Ways to Make Money in Real Estate. ...
- Renovation Flipping. ...
- Airbnb and Vacation Rentals. ...
- Long-Term Rentals. ...
- Contract Flipping. ...
- Lease to Buy. ...
- Commercial Property Rentals. ...
- Buying Land.
Because of the many tax benefits, real estate investors often end up paying less taxes overall even as they are bringing in more income. This is why many millionaires invest in real estate. Not only does it make you money, but it allows you to keep a lot more of the money you make.
What is the average rate of return for real estate over the last 10 years? ›Residential real estate has an average ROI of 10.6%, commercial real estate has an average return on investment of 9.5%, and REITs have an average return of 11.8%.
What is a good return on equity for real estate? ›Using ROE in Your Investments
While there is some general agreement about what constitutes a “good” ROE (~5% – 10% annually), it is also a somewhat subjective metric because each individual real estate investor's needs and objectives are different.
...
Average ROI of Real Estate.
| Property Type | 1-Year ROI | 1-Year Net* |
|---|---|---|
| Low-Rise Apartments | 9.0% | $11.88/ft2 |
| Multi-Family Home | 7.6% | $7.69/ft2 |
| Average Residential | 7.5% | $11.64/ft2 |
| New Single Family Home | 1.32% | $2.03/ft2 |
The most important factors that affect the profitability of real estate investment are location of the property, its condition, the rental rates, the growth of the community, the state of the real estate market, the mortgages, the timeline of the investment, the annual growth of the rental income, the annual growth of ...
What factor is most likely to influence demand for real estate? ›Which factor is MOST likely to influence demand for real esate? Wage levels and employment opportunities. When wage levels and job expansion are increasing, workers are more likely to buy real estate; when job opportunities are scarce or wage levels are low, demand for real estate usually drops.
What is the most important factor that makes a good home? ›
1. Location, location, location. Perhaps nothing is more important than the three L's, and there's a reason why it's said three times. Location is extremely important when it comes time to sell.
How are house prices determined? ›The housing market is influenced by the state of the economy, interest rates, real income and changes in the size of the population. As well as these demand-side factors, house prices will be determined by available supply.
What makes house prices go up? ›Normally that happens when the economy is doing well as more people are in work and wages are higher. House prices also tend to rise if more people are able to borrow money to buy houses. The more lending banks and building societies are willing to provide, the more people can buy a house and prices will rise.
How do you determine the value of real estate investment? ›Also known as GRM, the gross rent multiplier approach is one of the simplest ways to determine the fair market value of a property. To calculate GRM, simply divide the current property market value or purchase price by the gross annual rental income: Gross Rent Multiplier = Property Price or Value / Gross Rental Income.
What is the most common real estate transaction? ›The most common types of real estate transactions are buying/selling. The buyer usually pays the seller a certain amount of money.
Which of the following would be likely to reduce the demand for residential housing? ›decreased, while the supply of computers has increased. Which of the following would be likely to reduce the demand for residential housing? High mortgage interest rates.
What is micro market in real estate? ›In real estate development, micro-markets are subdivisions between geographical areas that have their own distinct and defining characteristics. These localities typically have properties at current market rates, making them more attractive to most city residents who are not searching for exorbitant investments.
What is cold calling in real estate? ›A real estate cold call is a way for realtors to find new clients by making phone calls and advertising their services. Usually, real estate professionals have no prior connection to the people they're calling.
Which type of real estate makes the most money? ›The answer is almost six figures for the average commercial real estate agent, which came in as the highest income out of all the agents we surveyed. Becoming an expert in commercial real estate could take more training — but it shows that more training pays off in this case.
What are the 7 major types of properties? ›- 1 Acoustical properties.
- 2 Atomic properties.
- 3 Chemical properties.
- 4 Electrical properties.
- 5 Magnetic properties.
- 6 Manufacturing properties.
- 7 Mechanical properties.
- 8 Optical properties.
What decreases home value? ›
Changes in the real estate market can lower the value of your home. Natural disasters and climate change can lower your property value because the property is a greater risk to purchase. Foreclosures in your neighborhood can also drive down property value.
What not to do before you sell your house? ›- Underestimating the costs of selling. ...
- Setting an unrealistic price. ...
- Only considering the highest offer. ...
- Ignoring major repairs and making costly renovations. ...
- Not preparing your home for sale. ...
- Choosing the wrong agent or the wrong way to sell. ...
- Limiting showings.
When thinking about what type of home if right for you, it is important to note that older homes typically sell for significantly less than a newer home would. In fact, according to a recent article in the Wall Street Journal, new construction comes at a 10-20% premium over older homes.