Tax Traps for New Real Estate Investors
By Stephen L. Nelson, CPA
Perhaps one shouldn’t be surprised that new real estate investors fall into the
same tax traps again and again. Real estate burdens investors—especially new investors—with
some tricky tax accounting.
But just because some other newbie makes these mistakes, that doesn’t mean you need
to. You just need to know where the traps are so you avoid them. And here are the
biggest real estate tax traps you don’t want to fall into:
Tax Trap 1: Passive Loss Limitation
On paper at least, real estate often loses money. Even if the rent pays the mortgage
and the operating expenses, the books still show a loss because you get to write
off a portion of the purchase price through depreciation each year.
If a rental house that cost $275,000 breaks even on cash flow, for example, you
might also get a $10,000 annual depreciation deduction. If your marginal tax rate
is 28%, that depreciation should save you $2800 annually.
Sounds sweet, right? Well, it is—or should be. Except that the U.S. Congress labeled
real estate investment a passive activity and said that, except in a couple of special
circumstances, you can’t write off passive activity deductions unless overall you
show positive passive income.
This passive loss limitation rule means that many real estate investors don’t get
to use tax saving deductions from real estate—or least not annually.
Two loopholes, courtesy of Congress, do exist that let you write off deductions
from real estate even if overall you show a loss from real estate investing. If
you’re an active real estate investor with adjusted gross income below $100,000,
you can write off up to $25,000 of passive losses annually. (If your income is between
$100,000 and $150,000, you get to write off a percentage of the $25,000. Ask your
tax advisor for the details.)
Here’s the second loophole: If you’re a real estate professional, Congress says
the passive loss limitation rule doesn’t apply to you when it comes to real estate.
A real estate professional, by the way, is not someone who’s licensed as
an agent or broker. The law instead creates a time-based test: A real estate professional
is someone who spends at least 750 hours a year and more than 50% of their time
working as a real estate agent, broker, property manager or developer.
Tax Trap 2: Capitalization of Improvements
The next mistake that new real estate investors make? Thinking they can write off
the amounts they spend to improve the property. Sometimes you can. Often you can’t.
Here’s why: Any expenditure that increases the life of the property or improves
its utility needs to be depreciated over the next 27.5 years (if the property is
residential) or over 39 years (if the property is nonresidential). You can’t, therefore,
write off the money spent improving or renovating a house—except through depreciation.
I’ve seen new real estate investors in tears about this wrinkle. Some investor draws,
say, $20,000 from his IRA or 401(k) to fix up some rental. He figures he’ll be able
to write off the $20,000 as a tax deduction in the year improvements are made.
The trick with renovation—if you want to call it that—is to keep the property well
maintained as you go. Repainting, new carpeting, general repairs—these items should
all be all deductions in the year of expenditure (er, subject to the passive loss
limitation rule discussed as the first tax trap.)
Tax Trap 3: Missing the Section 121 Exclusion
Here’s the final tear-jerker. And I see it several times a year. Someone decides
that rather than sell their principal residence when they “move up” to a larger
new home, they’re going to turn the original home into a rental.
This is a disastrous decision most of the time because of Section 121 of the Internal
Revenue Code . Section 121 says that if you’ve owned a home and lived in a home
for at least two of the last five years, you won’t pay any tax on the first $250,000
of gain on the sale ($500,000 of gain in the case of someone who’s married and filing
a joint return).
By converting a principal residence to a rental property, you turn tax-free gain
into taxable gain if you don’t sell the property in the first three years.
Two quick notes about goofing up the Section 121 exclusion. If you don’t have appreciation
in your old principal residence, you’re not losing any Section 121 benefit by converting
to a rental.
Second, if you do have a lot of appreciation in your old principal residence and
want to use that equity to acquire a rental property, consider this: Sell the old
principal residence when you move out so the gain is excluded from taxable income.
Then use the tax-free proceeds to purchase another rental—perhaps even the house
Stephen L. Nelson CPA has written more than 150 books. Formerly an adjunct tax professor
at Golden Gate University, Nelson taught the graduate tax class “Choice of Entity:
LLC vs S Corporation.” Nelson is also the author of the bestselling book Quicken
for Dummies, which sold more than 1,000,000 copies.