By Stephen L. Nelson, CPA, Guest Writer
Here are 10 tax loopholes that active real estate investors may be able to use to save hundreds of thousands of dollars of taxes over a lifetime.
#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!
[Editor's Note: Stephen L. Nelson, CPA, MBA, MS (taxation) 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. This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]
Great information, thanks!
As White Coat Investor mentioned in my first guest post last week, I really think the easiest first option for investing is to use things like IRAs and 401(k)s and then stuff them with low-cast index funds. That option is easy, fast, simple, etc.
However, if that doesn’t work or you want to save more than those options allow, direct real estate investment can work really work. Even, arguably, as well things like IRAs and 401(k)s.
Thanks for the tips and info… I fell into managing a rental when my full time job took me across the country… I have been using a few of these deductions but did not know about some the different methods for deducting repairs vs. capital expenses.. great stuff!!
So the genesis of this post and the post last week is that this real estate is complex enough that you can’t necessarily *easily* do it yourself with something like TurboTax. What’s more, the rules change fast enough, that even if you think you can get the info you need from an online forum or from a question you asked someone a few months ago, those sort of “old answers” may now be wrong.
Case in point: After I wrote this post but before it was published, the “de minimis” threshold mentioned in one of the tips (Loohole #3) above changed from $500 to $2500 as per this notice: https://www.irs.gov/pub/irs-drop/n-15-82.pdf
“You need to have a single real estate activity that crosses the 750-hour threshold” Is this really true? I though you need total hours that can include different things including maintenance, purchase of property, all other activities in general. If someone has multiple properties, spending 750 hours on just one property may not be really feasible even for full time real estate professionals
If you have multiple properties, you either need one activity (meaning one property) where you spend at least 750 hours… or you need to combine activities (properties) so the combination exceeds 750 hours.
This is a little bit tricky because once you combine activities (properties), you don’t dispose of the activity (and unlock any passive suspended losses) until you sell the last property. As a practical matter, then, what this means is that if you deal with the election to group multiple properties “late” you need to be careful you’re not shooting yourself in the foot.
Oops. I meant the $500 limit mentioned in Loophole #5… Arrgh!
The De Minimis is 2,500. I thought the 500 was old law. Also, the 750 hour test is much more complicated than you have described. Anyone interested in an indepth look should read this article from Forbes (if I am allowed to post it).
http://www.forbes.com/sites/anthonynitti/2014/07/09/tax-geek-tuesday-the-irs-finally-figures-out-the-real-estate-professional-rules/#2715e4857a0b1ed7b06c4760
The partial disposition rules and look back saved me a ton of taxes last year.
The $500 is not really old law… it’s actually the current regulation and, for the record, applies to 2015 tax year. The IRS Notice which changed the $500 to $2500 came out at Thanksgiving (and after I wrote the guest post)… and note that it’s really applicable to 2016. (See that link I provided if you’re interested.)
The 750 hour real estate professional does not to me seem much more complicated that I described here. And I don’t think the Forbes tax article (which I’ve just read) provides much additional information. But that said, yes, there’s more to real estate tax law that I can cover in a couple of 1000-word posts.
Actually, if some White Coat Investor reader wants to take another step into this topic and get out into a little deeper water, here’s a recent blog post I did that goes into more detail that that 700 word Forbes article:
http://evergreensmallbusiness.com/real-estate-vs-ira-and-401k-accounts-part-i/
Okay, sorry, last compulsive post on this subject… I missed the fact that Forbes, playing the search engine optimization game, wants a reader to page through several pages of article “chunks” and that the writer has wrapped in a discussion of material participation and then a discussion of the grouping election. So let me also address those points.
1. In any investment activity, including real estate, you need to materially participate in order to deduct losses in the years before you dispose of the activity. So if you or your spouse qualified as a real estate professional (because you spent 750 hours a year on real estate) but then failed the material participation rules, sure, you could find you ‘win’ one test and ‘fail’ the other test. This seems terribly unlikely to me as a practitioner. (Some of the rules are really easy.) But, sure, maybe one can construct scenarios where this result occurs. BTW, there are other rules that limit losses too… so this is a little bit alarmist in a sense. But whatever…
2. If you have multiple real estate properties and don’t send more than 750 on any single one of them, you easily fix this by making an election to group the activities so as a group the hours total 750 hours a year. I would call this pretty basic tax accounting knowledge though…
Your article and the Forbes article are completely unrelated. The 700 word Forbes article is actually 6 pages and written by a well respected tax attorney.
You are right. As noted, I initially missed the button to click through his six pages. So I was initially looking and comparing only his first chunk.
As a side note, I read your other article and thought it was pretty good.
The 500 is old law. The IRS will not challenge the 2500 deduction taken on a 2015 return… so I am not sure why anyone would use 500.
For any accounting I was still doing, like you, I would not use the $500. I would also use $2500. But the $500 amount is actually the current law for 2015. And people with real accounting systems who went through 2015 using the $500 capitalization limit might not want to redo that work.
BTW, so that someone reading our messages doesn’t think there’s an argument here, I agree with David that the IRS Notice says the IRS won’t challenge the higher capitalization limit if it’s used before 2016. Which also makes sense. Why $2500 is okay for 2016 and later years but then is a problem for earlier years… well, gosh, that’d be just plain crazy.
Does any of this matter to the White Coat Investors reading this? Maybe not… but just for hoots, note that if you’re a practice owner that $2500 higher limit is available for your business too. And the $500 to $2500 change occurred very late in the year–nearly all the bookkeeping was done for 2015 by the time people got back from Thanksgiving. So you might, if you own the practice you work in, look at the capitalization limit used for 2015.
Agreed. No argument but rather debate/conversation. I read through all the whole life discussions, multiple 401k contributions, etc. so it is good for doctors to read through all this jargon.
Yes, this site’s readers aren’t afraid to get WAAAAY out into the weeds on many topics.
I actually think the real estate professional rules are complicated compared to other sections but if you think it is easy than that is great.
There’s a comment of mine awaiting moderation which when posted will address some of the variance in our points of view. But I think we may be using the phrase “real estate professional” as a handle to refer to different topics. I do think that qualifying as a real estate professional is pretty easy–and that anyone who wants to can (with planning) do it.
That said, the Forbes article raises other issues like material participation which need to be considered for real estate (and for other ventures and investments). And there are other issues, too, which one needs to consider–like at-risk limitations. And the effect of disposing of an activity. This other stuff? Some of it is harder to deal with… and if one uses the handle “real estate professional” to refer to the entire process of avoiding the passive loss limitation stuff, well, yeah, one definitely needs to be careful. And cautious.
Hmmm interesting tips here. Not sure how much of this applies to Canada. As a real estate investor, I’d be cautious with some of the loopholes, like using the title professional real estate investor.
I would say that nothing in the articles applies if you are not filing a US 1040 tax return.
Thanks for the tips, im only 18 so im not exactly at the point in my life to invest into real estate, but id definitely remember these loopholes for when the time comes!
I hate things like this being called loopholes. I understand why you call it that (to pique the interest of the reader), but it suggests some sort of inequity and that these “holes” in the tax code need to be closed.
The step-up in basis at death exists because death is a taxable event whereby gain (or loss) is recognized upon transfer of the asset. I.e., it’s not a loophole, but a provision that the code provides for taxpayers upon a realization event, like any other.
My dad is a real estate professional and he enjoys many of the tax benefits. But he is a bona-fide real estate professional, and it’s a full time job. The income he derives from real estate, being a landlord and developer, is hardly passive.
Furthermore, most of those safe harbors and depreciation provisions are simply reflections of economic reality.
That said, this is a good article and I appreciate the content
You’re right, Craig, that these items (or most of them anyway) are not technically loopholes.
And I agree with you that these are not necessarily “holes in the tax code” that need to be closed. In fact, I don’t think any of these items should be eliminated. For what that’s worth…
Note: Death in most cases doesn’t trigger a taxable transfer. At a federal level, basically only if the estate exceeds the roughly $5.5M per individual (roughly $11M per married couple) limit.
Sorry late to the discussion,’
Thanks for the article
Had a few qn-
On a scenario where an individual sole job is managing rental properties he/she owns. There is no property manager involved – the individual does the advertising, background checks and other selection, manages tenant and property, hires workers for any repairs/maintenance – in brief runs the properties by self . Consider they have elected to “aggregate” all real estate properties, as single..
1. If an individual is a real estate professional(REP) solely by having /managing own personal rental properties – is that income passive or earned – is that income passive/earned – if earned is he/she eligible to contribute to a solo 401k?
2. By your experience, “on average” how many rental units “does it take ” for a individual for the irs to consider the individual to meet the criteria for REP, considering this is their sole “job”?
3. What activities count and do not count for material participation, for the irs? showing properties/advertising/looking at properties to buy..?
Thanks
To answer question #1, real estate rental income is passive. So generally you can’t use it to create earnings for a pension. Note, though, that in an earlier comment I included a link to a post at my blog that explains how someone can use real estate as a substitute for a 401(k). See that link maybe… (The comment and link BTW weren’t really on topic as an answer to the reader I responded to… but it is on topic for your question.)
To answer question #2, I think you could probably have 2-3 pretty large properties (4-plexes or 6-plexes or 8-plexes) and maybe *still* fall under the 750 hours a year. But if you spend a lot of time “ramping up” your property management business, gosh, I think crossing the 750 hour threshold should be pretty easy. (Sidebar comment: There’s a lot of learning involved in getting truly expert about something like real estate. You could easily spend 200-300 hours on that your first year or two, IMHO.)
To answer question #3, I think anything you can fairly roll into the “property management” role can be counted toward the 750 hours. And given the dollars involved, gosh, it would seem to me to be extremely reasonable to count your research time, training, etc.
Re #1: thats whats is confusing about the REP status: per law once you attained REP status your activities are no longer passive …. but the income is still classified as passive ?
Here’s the way I think you “understand” the law, which appears here:
https://www.law.cornell.edu/uscode/text/26/469
People can’t deduct passive losses… passive losses include real estate… except this limitation doesn’t apply to real estate professionals. (Read subsections (a)1, (a)2 and (c)1, (c)2 and (c)7 if you want to get into the weeds on this.)
So what we’re really talking about here are passive losses and not passive income. There is no passive income limitation. Only a passive loss limitation.
BTW, you can’t use the passive income from real estate rentals to support pension fund contributions directly though people can get around this by creating a property management corporation, having their properties pay the property management corporation enough money to create earnings, and then using those earnings to create an opportunity for pension fund contributions. This probably doesn’t really make sense in most situations because of the heavy payroll taxes incurred.
Final point: I think if you want to save money for retirement or the long haul and you’re willing to use real estate to do so, you don’t need to use a pension for that wealth building. Adding a pension is an unnecessary whistle or bell. The real estate will (if you want it to) create a mechanism to grow your savings via pre-tax income because of the depreciation deductions you’ll get.
Payroll taxes aren’t so bad for a doc or similar high income professional, since it would just be Medicare taxes.
Thanks for explaining/clarifying the details
One other thought: If someone is spending time renovating properties, I bet you’d be able to cross the 750 hour finish line pretty easy. Painting, repairing, re-landscaping, etc. will take a lot of time.
Just as an FYI Turbo Tax 2016 takes you through the option for the $2500 De Minimis Safe Harbor Election for your rental property, so they seem to be keeping up with at least this rule fast enough.
According to Turbo Tax, here are the rules you need to meet to take this election:
– You don’t have an applicable financial statement (most people don’t).
– You have a consistent process for how you record expenses and assets (basically treat costs as an expense and not depreciate them).
– You record these items as expenses on your books/records.
– The cost of each item as shown on your receipt is $2,500 or less.
Stephen, I hope you are still responding to comments on this post. If so, would you please address two items related to depreciation and the alternative minimum tax (AMT). My wife and I own two rental residential properties. For the past several years we have been hit by the AMT. It appears to me that one practical effect of the AMT is that while I claim depreciation over 27.5 years, the AMT actually stretches that to 40 years. If you agree that is correct, then my first question is how to determine when the property is fully depreciated? I’ve always just assumed 27.5 years, and the AMT is simply reducing the tax benefit of the depreciation. Is that right? My second question is what would be the impact of the AMT on any items I depreciate using segmented depreciation?
Those are great questions. I’m sure Stephen knows the answer (or where to find it). If he doesn’t respond to your question here, let me know by email and I’ll get you in touch with him.
As a real estate professional, many will find that they need to aggregate their real estate activities in order to meet the 750 hour requirement. This election should be made on the tax return, but if it was not made then help is on the way.
The IRS issued Rev. Proc. 2011-34, which allows real estate professionals who qualify under the law to make a late election if it was missed on their initial tax filing. This would allow the taxpayer to aggregate all rental real estate activities in order to satisfy material participation under the passive activity rules. This would allow the taxpayer to make the late election on an amended tax return. I hope this helps.
Anyone give me advice on helping mother of 2 kids not paying rent or helping with bills im pretty much flipping bill for her and she nit helping living in my home hiw can i rite off stuff for her using me any loopholes. Or am i in a corner with no way out
Not much available there tax wise. Very nice of you though. Make sure you’re actually helping her in the long run and not enabling her of course.
There is a credit for “other dependents” but they still have to be related to you:
https://ttlc.intuit.com/community/children-dependents/help/what-is-the-500-credit-for-other-dependents-family-tax-credit/00/27458