[Editor's Note: This is a guest post from Stephen L. Nelson, CPA, MBA, MS (taxation) who is a managing member of a CPA firm in Seattle. A prolific writer, he has written more than 160 books which have sold more than five million copies in English, including Quicken for Dummies and QuickBooks for Dummies. We have no financial relationship.]
Here are ten tax loopholes that active real estate investors may be able to use to save hundreds of thousands of dollars of taxes over a life-time.
#1: Active Real Estate Participants Sidestep Limitation
If you’ve done any research, you know that though real estate write-offs like depreciation produce big deductions, you typically can’t use those deductions to shelter earned income or investment income. However, tax law does provide two loopholes for sidestepping this limitation (called the Section 469 passive loss limitation). You want to know about both loopholes. The first way to sidestep the passive loss limitation? Using the “active participant” pigeonhole.
Specifically, if a taxpayer makes less than $100,000 a year and the taxpayer has a bit of involvement in the real estate investment, he or she can write off up to $25,000 a year in passive losses. The $25,000 loophole, by the way, gets phased out as your income rises and disappears once your income reaches $150,000. Accordingly, this loophole isn’t very attractive to highly taxed individuals looking at real estate as a way to grind down their income taxes. But if you’re interested, refer to the IRS’s instructions for preparing Schedule E.
#2: Real Estate Professionals Sidestep Limitation
Tax law also provides another, better way to sidestep the passive loss limitation rules: If a taxpayer or a taxpayer’s spouse spends more than half his or her work time and at least 750 hours on real estate, the passive loss limitation rules simply don’t apply because the person is considered a “real estate professional.” Spending time on real estate, by the way, means working as a real estate agent or broker, a real estate developer, or a property manager. But note that no professional license is needed.
Accordingly, an investor who works a couple of days a week managing his or her rentals absolutely qualifies as a real estate professional using the property manager label. That then means the taxpayer and his or her family sidestep the passive loss limitation and the family may be able to use big real estate losses to shelter big earned income or big investment income amounts. For example, if one spouse in a white-coat job earns $500,000 a year and the other spouse (a real estate professional) loses $200,000 a year, the family’s adjusted gross income equals $300,000.
Note: The 750-hour rule is tricky. You need to have a single real estate activity that crosses the 750-hour threshold. Accordingly, if you have two apartment houses and each takes 400 hours of time, you don’t cross the 750 hour threshold unless you tell the IRS you want the two apartment houses treated as a single real estate activity. If you decide to get into real estate, therefore, be sure to ask your tax adviser about how this works before you buy your second property.
#3: Real Estate Professionals Sidestep Obamacare Surtax
As you probably recall, Obamacare includes a 3.8% surtax, which potentially gets levied against investment income and gains, including real estate rental income and gains. Specifically, if your income exceeds $200,000 and you’re single or if your income exceeds $250,000 and you’re married, you get hit. But there’s an exception real estate investors need to know: the 3.8% Obamacare surtax doesn’t get levied on the rental income and gains earned by real estate professionals.
#4: Cost Segregation Jacks Depreciation Deductions
Normally, residential real estate gets depreciated over 27.5 years and nonresidential real estate gets depreciated over 39 years. This might mean that a $1,000,000 property which consists of an $800,000 building and a $200,000 piece of land produces $20,000 to $30,000 a year of depreciation deductions.
You can, however, use a trick called cost segregation to frontload your depreciation into the early years of ownership. And this maybe makes sense if you can match large depreciation deductions with large income amounts. Cost segregation works basically like this: An engineering firm comes out, looks at your $800,000 building, and says, “Well, another way to look at this thing is as if it’s a $500,000 building and $300,000 of fixtures and equipment.” While the $500,000 building needs to be depreciated over 27.5 or 39 years, the $300,000 of fixtures and equipment can usually be depreciated over a few years–and mostly in the very first years.
#5: De Minimis Expenditures Safe Harbor
In 2013 and 2014, the Internal Revenue Service implemented new “Tangible Property Regulations” (hereafter TPRs) which describe how to handle supplies, repairs and maintenance expenses. These new regulations provide a bunch of nifty new real estate related tax loopholes.
One such loophole, for example, is the “de minimis” safe harbor which says that if you spend $500 or less on some item, you can just deduct the item. For example, if you buy ten $500 appliances for your apartment house, you can simply write off in the year of purchase the $5,000 spent for the appliances.
#6: Routine Maintenance Safe Harbor
Another new real estate investor loophole in the new TPRs is the routine maintenance safe harbor. The routine maintenance safe harbor says if you make a repair several times during the years you owe the property, you can deduct the expenditure.
#7: Small Taxpayer Safe Harbor
The TPRs include a small taxpayer safe harbor which applies if your average income is less than $10,000,000 and your building’s unadjusted basis is $1,000,000 or less. The small taxpayer safe harbor says that if the amounts you’ve spent on repairs and maintenance for a building is less than the lesser of $10,000 or two percent of the building’s original cost, you can just deduct the repairs or maintenance.
#8: Partial Dispositions
The new TPRs also include a couple of loopholes related to disposing of a property or a chunk of a property. Here’s the first “disposition” loophole: If some improvement or repair replaces an item you’ve previously been depreciating, you can write off the rest of that old item’s undepreciated cost and also remove the accumulated depreciation from your tax return. For example, if you put on a new roof, you do need to depreciate the new roof, but with the new TPRs you get to write off whatever is left of your old roof. (This is part of the benefit and probably produces an immediate tax savings.)
Also, whatever depreciation you accumulated on the old roof, by writing off the rest of the old roof, won’t have to be “recaptured” when you later sell the property. (This is another part of the benefit and will absolutely reduce the amount of depreciation you “recapture” when you sell.)
#9: Late Dispositions
Okay, one thing that’s probably too late to do anything about now… but then again maybe not if you still owe a tax return for 2014…For 2014 tax returns, you can do “late” partial dispositions for things such as roofs you’ve replaced in earlier years (in other words, before 2014).
If you were working with a good accountant, he or she probably talked with you about this. And you may have even done this. Note though that someone needs to do some semi-complicated accounting in order to show late partial dispositions on a tax return and needs to file a change in accounting method form. This is/was not a DIY project.
#10: Section 1014 Step Up in Basis
Appropriately, I end this list with the last real estate tax loophole you’ll enjoy. Under current tax laws, when you die, the basis of assets you own gets stepped up to fair market value. For example, if you bought a $1,000,000 building decades ago and have actually fully depreciated it, the basis steps up to $1,000,000 when you pass away. If your heirs sell the building for $1,000,000, they will book no gain nor recapture any depreciation. And note that if they keep the property, they can begin all over again depreciating the building.
And an important point about community property situations: In a community property state, the basis of community property gets stepped up to fair market value when either spouse dies. If you think about this a bit, you won’t be surprised that some “real estate” families are using Section 1014 to buy and depreciate high quality buildings. And then depreciate them again. And again. And again.
What do you think? Are you or your spouse a “real estate professional?” Which of these deductions do you use? Which are new to you? Comment below!