Since the introduction of the Tax Cuts & Jobs Act in 2017, many real estate investors have wondered how these new rules and incentives affect their taxes. Things were so confusing in fact that the IRS recently released clarification on the 20 percent pass-through deduction, and specifically singled-out real estate investments as needing more clarity. To answer some of these questions, I sat down with Brandon Hall, CEO and founder at The Real Estate CPA.
Heath Silverman (CEO, Stessa): Welcome, Brandon, I’d like to start with a quick question about the basics. What are the key things that all real estate investors should be doing in preparation for taxes?
Brandon Hall (CEO, The Real Estate CPA): Thanks, Heath, for the opportunity to talk about my favorite subject. The basics of real estate investing taxes are quite simple—organization and preparation. This means diligent and digital record keeping, having a home office, having the right corporate structure to protect you and your business, and wrapping your head around common tax misunderstandings such as how travel works as a business expense.
Silverman: In the same vein, what are the common misunderstandings about travel? Because, as real estate investors, we are doing this on a regular basis and typically need to do so to scale our business.
Hall: In general, business travel must be considered both “ordinary and necessary” to be tax-deductible. Ordinary means it is common and accepted within the trade or business. Necessary means it is helpful and appropriate for the trade or business. As a real estate investor, you’ll likely travel to and from your rental properties, other business locations, new markets, and education-related events. While most of these activities are ordinary and necessary, it is important to understand the various rules for deducting travel expenses.
For local travel, you have a home or local office, and these miles driven are considered business miles and are tax deductible within your “tax home.” Your “tax home” is considered the geographic location (i.e. city or locality) where you have an established rental business. There are generally two ways you can deduct these trips: 1) using the actual expense method, or 2) the standard mileage deduction. Both require you to keep an IRS-compliant mileage log.
Travel expenses incurred to research and evaluate any new property that you eventually purchase outside of your tax home, will be added to the basis of the property and depreciated over 27.5 years, according to Revenue Ruling 77-254 of the U.S. tax code. Once you purchase a rental property in the new geographic area, additional new travel to the same area to evaluate other potential acquisitions becomes tax deductible as a business expense.
That said, it’s worth noting that all real estate investors should have a trusted accountant with which to discuss their specific situation.
Silverman: Let’s dive into real estate tax strategies and incentives. What are some of those strategies that you see investors missing on a regular basis?
Hall: Let’s start with 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. Rental property investors will sometimes purchase a property vacant and in need of significant renovations. Any renovation costs incurred before you place the property in service must be capitalized and depreciated, rather than deducted as an expense that tax year. 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.
The key here is that the property is "ready" and "available" for rent in order to be placed into service. “Available” means advertising the unit for rent whereas “ready” means habitable. Be sure to check your local ordinances on whether you need a certificate of occupancy as that will be required before your unit will be deemed "ready" for rent. 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.
Another strategy is passive losses versus income, and how to treat these. This is a much larger discussion, but 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. For example, your MAGI is $100,000 for the year and your rental properties produce a net loss of $30,000. As long as you demonstrate active participation and own at least 10% of the value of all the interests 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.
A final strategy I will mention here is when selling properties, there are several strategies real estate investors need to explore before making any decision to minimize their tax burden—1031 exchanges, tax loss harvesting, and opportunity-zone investing. If you aren’t aware of these incentives, please go read up on them and ask your accountant.
Silverman: We’d be remiss if we didn’t discuss the new 20% pass-through deduction that the IRS recently clarified. How does this work and what should real estate investors know?
Hall: The Tax Cuts & Jobs Act of 2017 introduced a new 20 percent pass-through deduction allowing certain business owners to deduct 20 percent of qualified business income if your taxable income is below $157,500 if single, or $315,000 if married.
So, if you still have taxable income from your rental properties after following the strategies I mentioned above, you may qualify for the 20 percent pass-through deduction under the following safe harbor. The safe harbor focuses on when a “rental real estate enterprise” will qualify as a “trade or business.” A rental real estate enterprise is an interest in real property owned by an individual, disregarded entity, partnership (other than a publicly traded partnership), or S-Corporation. The safe harbor will apply only to interests in a rental real estate enterprise as long as all of the following conditions are met:
- Separate books and records are maintained to reflect income and expenses for each rental real estate activity or enterprise (a separate real estate enterprise may constitute multiple properties as long as it is all commercial or all residential).
- 250-plus hours of rental services are performed for the enterprise.
- You maintain contemporaneous records, including time reports or similar documents, regarding: a) hours of all services performed, b) description of all services performed, c) dates on which such services are performed, and d) who performed the services.
Keep in mind that if you plan on taking this deduction, there are many other things to consider, like you'll have to issue Form 1099 for all independent contractors to which you paid over $600 during the year.