Real Estate Tax Planning and Compliance
As a real estate investor, it's essential to understand the importance of tax planning and compliance. Real estate tax planning and compliance refer to the processes of identifying tax-saving opportunities and ensuring that you are complying with tax laws and regulations. Proper tax planning can help you minimize and manage your tax liability and maximize your return on investment, while compliance ensures that you avoid penalties and legal issues.
Rental income from any real estate property must be reported on your yearly tax return. This includes all forms of revenue such as rent, fees, and other payments received by the landlord. In order to maximize deductions and reduce income taxes, associated expenses like mortgage interest, property taxes, insurance premiums, repairs and maintenance should also be reported.
If you are a cash basis taxpayer, you report rental income on your return for the year you receive the rental income, regardless of when it was earned. By the same token, as a cash basis taxpayer, you generally deduct your rental expenses in the year you pay them. If you use an accrual method, you generally report income when you earn it, rather than when you receive it and you deduct your expenses when you incur them, rather than when you pay them.
Most individuals, businesses and small companies use the cash method of accounting. So, most rental activities can be accounted by taking into consideration all deposits in your rental bank accounts and all rental and lease-related payments. Your cash income is what you deposited minus what was paid from your account during the year.
In this article, we will discuss the key financial strategies that investors can implement to achieve their financial goals.
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What is considered rental income?
You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. Rental income is payments received from tenants for renting out your primary or secondary residence, as well as from subletting or renting out a part of your home, such as a room, garage, basement, or other space. For real estate investments, rental income includes the fair market value of any goods or services received in lieu of rent or in addition to cash. The security deposit that you receive at the beginning of the lease is not considered rental income. However, if you keep the security deposit at the end of the lease, the security deposit becomes rental income. It is advisable to deposit your security deposits in escrow if you have more than one rental property.
Reporting rental income on your tax return
When reporting rental income on your tax return, it is important to accurately record all of the money you have received from rental properties. Rental income should be reported on a Schedule E form (Supplemental Income and Loss). This form is used by landlords to report rental income or losses from investment or business real estate. You will need to provide information regarding the number of rental units, the type of property (single-family, duplex, triplex, etc.), street address and other related information.
What deductions can I take as an owner of rental property?
If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return. These rental property expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs. You can deduct all ordinary and necessary rental expenses for managing, conserving and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business. Necessary rental expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities and insurance. With the use of sophisticated software, most tax preparers will be able to help you deduct all rental property expenses on your tax return.
Real estate tax planning
Real Estate Tax Planning is a critical component of any successful real estate investor's strategy. It involves proactively looking for potential tax-saving opportunities and structuring investments in line with the latest tax laws and regulations. The primary goals of rent real estate tax planning services are to minimize tax liability, maximize return on investment, and ensure compliance with all applicable taxes. If you use a CPA as your tax preparer, they will be able to plan for your rental properties' investments. It is a common service provided by CPAs but be aware that not all CPAs specialize in real estate accounting.
Top 15 tax planning strategies for real estate investors
Business entity - structure your business for tax efficiency. It is important to consider the tax implications when deciding how to structure your real estate business. Business entities are an important consideration for investors as they can provide several tax and asset protection advantages. Setting up a business entity, such as a Limited Liability Company (LLC) or a Corporation, can provide the ability to separate your personal and business assets. This can be beneficial from both a tax and legal standpoint as it limits your personal liability for the activities of your business.
Additionally, many business entities such as an LLC or S-Corp can provide tax savings by allowing you to take advantage of tax deductions and credits that you may not be eligible for as an individual taxpayer. We have seen investors not owe taxes or even get a tax refund when they use an LLC, more than when they use other types of business structures.
Depreciation - Take advantage of depreciation deductions: Depreciation allows you to deduct the cost of your investment property over a period of time on your tax return. This can be beneficial as it may allow you to offset some or all of your rental income, thereby reducing your taxable income. Depreciation is a non-cash deduction that can reduce your taxable income and maximize the return on your real estate investment. Good tax software can help with the calculation of your depreciation and account for all rental expenses on your tax return.
Section 179 Depreciation - Accelerate your deductions: Section 179 of the Internal Revenue Service (IRS) code allows investors to immediately deduct an IRS-specified large amount in qualifying business expenses in the year they are purchased. This can be beneficial as it allows investors to accelerate their depreciation deductions, thereby reducing taxable income and increasing cash flow.
Depreciate capital investments: Capital investments, such as appliances or furniture, can also be depreciated over time. This allows investors to deduct the cost of these items on their tax returns and reduce their taxable income.
Cost segregation - Accelerate your depreciation: Cost segregation is a strategy that allows investors to break down the costs of their investment property into shorter deductions. This can result in significant tax savings, as it can allow for faster depreciation deductions on certain components of the property, such as appliances or fixtures. There are many tax preparers that are not aware of this strategy.
Rental deductions - maximize your rental deductions: There are a number of deductions available to real estate owners that can help reduce your taxable income. Some common rental deductions include mortgage interest, insurance premiums, advertising expenses, legal and professional fees, taxes, repairs, and maintenance expenses, travel costs related to the property, and more. Keep records of your rental expenses during the year so you do not miss any deductions during your income tax preparation.
Qualified Business Income Deduction - reduce profits by 20% deduction by law: Take advantage of the Qualified Business Income Deduction (QBI) to reduce your taxable income. QBI is a tax deduction that was established as part of the Tax Cuts and Jobs Act in 2018 and allows for a 20% deduction on qualified business income. Real estate investors can take advantage of this deduction by ensuring that their rental activities are classified as a trade or business and meet other requirements established by the IRS. An expert tax preparer will not miss this deduction especially if he is using tax software to prepare Schedule E of your tax return.
Tax Credits - take advantage of tax credits: Additionally, there are a variety of federal and state tax credits available to real estate owners that can help offset their taxable income. Common credits include energy efficiency credits, which provide a credit for the installation of energy-efficient improvements such as solar panels or Energy Star-qualified appliances, as well as Historic Preservation Tax Credits and many other credits.
The 1031 Exchange - defer the recognition of gains: Investors can take advantage of a 1031 exchange to defer the recognition of gains on their investments. A 1031 exchange allows an investor to sell an investment property and reinvest proceeds into another similar property without having to pay taxes on any capital gains from the sale. This can be beneficial as it allows an investor to defer the recognition of gains and continue to grow their investment portfolio.
Long-Term Capital Gains Rate - own the property for more than 1 year: It is important to note that the long-term capital gains rate for real estate investments is typically lower than ordinary income tax rates. As such, investors can take advantage of this break and defer their capital gains taxes by investing for the long term. You should only sell your real estate investment after one year of purchase.
Own Properties in a Self-Directed IRA - Save on taxes by using your retirement: Real estate investors can also benefit from investing in properties through a self-directed IRA or retirement plan. By investing in real estate through these plans, individuals are able to defer their taxes until they begin to withdraw funds from the account. This can help maximize returns and reduce tax liability.
Installment sale - Sell part of your property over time: Another strategy to consider is an installment sale. An installment sale allows a real estate investor to sell their property and receive payments over time, thus deferring the recognition of gains. This can be beneficial for investors with large properties as it can help them spread out the capital gains taxes due and increase their cash flow.
Home exclusion - exclude some of your gains from taxes: Investors can also take advantage of the home exclusion when selling their primary residence. This allows up to $250,000 (or $500,000 for married couples filing jointly) in capital gains from the sale of a home to be excluded from taxable income.
Property Tax Reduction - reduce your property taxes: Lastly, investors should make sure to take advantage of any available property tax reduction or abatement programs that are offered by their local government. These programs may provide for a reduction in the amount of taxes due on the investment property and can help bring down the investor’s overall tax liability. There are many attorneys in your community that provide real estate reduction services.
Loans - borrowing money is okay: Investors should also consider taking advantage of loans or lines of credit to fund their investments. Borrowing money can help reduce the amount of capital invested up front, increase your ROI and can provide more flexibility when it comes to cash flow management. Finally, the interest you paid on the loan is tax deductible from your rental property activities.
Real estate tax compliance / Reporting rental income on your tax return
In addition to planning for taxes, real estate investors must also ensure that they are compliant with applicable tax laws and risk rules and regulations. Tax compliance is critical for investors as failure to comply with tax rules can result in hefty penalties and fines. Therefore, it is important for investors to familiarize themselves with the relevant local, state and federal tax laws and regulations. You should prepare your rental property tax and pay the tax due by the filing deadline to avoid penalties and even more if you are due a tax refund. The following are the key compliance requirements for real estate investors:
Real estate property taxes also known as ad valorem taxes are collected annually by your local government. It is important to pay your real estate property taxes because otherwise, you can lose your property. If you don't agree with your local government assessment, you can appeal the assessed value. There is no tax filing requirement for this tax obligation, just pay it on time.
Note: Local tax issues for real estate can vary depending on the location and specific tax laws in that area.
Rental income tax
Every year you must file an individual and/or business tax return with the IRS and your state or local tax authority, in order to report your rental income. Depending on the size of your rental business, you may also have to file other forms such as Form 1099-MISC for non-employee compensation.
Rental property owners report their rental income or loss from rental real estate in their personal income tax return Schedule E of Form 1040, or in their LLCs or Corporations, or Trusts using the rental and Schedule E, if necessary. As a real estate investor, you will also need to file Form 4562 to take advantage of your rental depreciation and amortization expenses. Remember, paper returns are things of the past now and e-filing is the way to file your return and Schedule E.
Sales tax on rental property
Depending on the state your property is located in, you may have to pay sales tax when renting out a property. In certain states, like California and Arizona, all rental fees must be reported and you could be subject to pay sales or use taxes. In Florida, you have to pay sales tax on short-term rental income. Sales taxes are paid on your total income received and not on your net income and sales taxes are paid by the tenant. You are responsible for collecting the sales tax from the tenant and send it to the government. It is important to review your local state laws and determine whether or not there are any additional reporting requirements for rental income. You can pay a tax preparer to teach you how to prepare your own sale tax returns.
Capital gains tax
Investors must also consider paying the capital gains tax when they sell or exchange properties. The capital gains are calculated by taking your net gross proceeds from the sale of the residential rental property, minus all of your costs associated with owning, purchasing, maintenance, closing cost, legal fees, etc. The sale or lease of the property must be reported by the owner of the property when filing the annual income tax return. If you fail to report the transaction, you will receive a letter from the IRS because all real estate transactions are reported to the government by the closing agent.
Real estate investors must also make estimated tax payments throughout the year to cover their federal and state income taxes, self-employment taxes and other taxes. The estimated tax payment should be made on a quarterly basis, but certain states may require more frequent payments every month or semi-monthly payments. The amount of your estimated tax payments depends on your projected income, deductions, and credits.
Estate and gift taxes
Finally, real estate owners must also consider estate taxes when transferring properties to heirs and beneficiaries. Estate taxes are imposed on the fair market value of property and money that is transferred to someone else at the time of death. The exact amount of tax would depend on the size of all your properties and estate and other relevant factors.
You may also be interested in reading U.S. Individual Income Tax Preparation
What are rental losses?
Rental losses occur when the expenses incurred in running a rental property exceed the income generated by it. This can happen due to various reasons, including declines in rental rates due to market conditions, unexpected maintenance costs, and vacancies caused by tenants leaving without paying rent or depreciation or amortization expenses or other tenant-related issues. Usually, rental estate investors benefit by deducting real estate losses against other income.
How are rental losses classified for income tax purposes?
Rental losses are classified as passive losses for income tax purposes. Passive losses result from activities that involve no material participation by the taxpayer, such as rental income derived from real estate. You must be aware of the passive activity loss limitations. Passive losses can only be used to offset passive income, such as capital gains or income earned through other passive activities. If the taxpayer does not have any passive income to offset the losses, the excess amount can be carried over to future years.
What exceptions to passive loss rules allow for the deduction of passive losses?
Two main exceptions to the passive activity loss rules allow for the deduction of passive losses. The first exception occurs when a taxpayer or their spouse qualifies as a real estate professional, meaning that they spend more than half of their working hours managing the rental activity and more than 750 hours per year in that activity. The second exception is based on a taxpayer’s income. If the taxpayer's modified adjusted gross income (MAGI) is less than the specified amount by the IRS, they can deduct up to $25,000 of passive losses against their non-passive income.
At-risk limitation rules
The at-risk rules limit the amount of losses a taxpayer can deduct from their taxable income in any given year. Under these at risk rules, taxpayers can only deduct up to their adjusted basis (the original cost of the investment, plus certain improvements and other expenses associated with the property). Any losses that exceed the taxpayer’s adjusted basis for the activity are considered suspended losses, which can be carried forward to future tax years.
What records should I keep?
Good records are essential for real estate investors when it comes to tax planning and compliance. Potential records that investors should keep include all rental income, expenses, closing costs, legal fees, capital gains taxes, estimated taxes, and estate and gift taxes. These records should be kept in an organized and up-to-date manner with easy access for preparation final review of tax returns and to support audit requests. Additionally, investors must maintain records that substantiate certain elements of expenses when preparing their tax returns in order to take advantage of rental deductions and credits.
Keeping accurate records is critical for real estate owners to ensure compliance with all applicable tax laws, rules and regulations as well as optimize their return on investment. As per the IRS website: You must be able to substantiate certain elements of expenses to deduct them. You generally must have documentary evidence, such as receipts, canceled checks, or bills to support your expenses. Just remember, you must keep track of your rental expenses and capital improvements.
Tax planning and compliance is an essential parts of a successful real estate investing strategy. With proper tax planning, investors can minimize their tax liabilities and maximize their return on investment, while avoiding costly penalties and legal issues. To achieve this, investors must hire a qualified tax professional to identify opportunities for saving taxes, choose the right investment structure for their financial goals, keep accurate records and stay up-to-date with local tax laws. By implementing these strategies, real estate investors can ensure that they are in compliance with all applicable tax laws and regulations as well as maximize their return on investment. The success of any real estate investing strategy depends largely on proper tax planning and compliance.
How H&CO can help you
At H&CO, we have a team of experienced tax professionals (CPAs) who can help you with the preparation and filing of your real estate tax returns or any of your income tax returns. This includes any international tax issues as well as a taxable estate, among many others. Our experts can assist you in understanding the latest changes in tax laws and regulations, maximizing deductions and credits available to you, and correctly calculating your taxable income and overall tax liability. We also offer comprehensive services such as tax filings, structuring your real estate investment, doing your monthly real estate accounting and many other real estate tax services.
H&CO's bilingual trusted CPA Tax Advisors have been helping high net-worth individuals, family offices with significant income, business owners, investors, global families, and foreign individuals with their income tax preparation, for over 30 years. You can talk to our CPAs in one of our offices near you in Miami, Coral Gables, Aventura, or Fort Lauderdale. Our international CPAs are ready to assist you with all your income tax planning and income tax return preparation needs. If you are interested in some of our other global tax services, take a look at our business tax services or international tax services.
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