Why Some Real Estate Investors Don’t Get Any Tax Breaks

Apart from rent and appreciation, there are plenty of other things real estate investments offer to the investors. Perhaps the most beneficial aspect of the whole process is the number of tax breaks that one may enjoy. Thanks to depreciation, expense write-offs, and other sophisticated tax-planning techniques, you can legally decrease your tax bill.

Unfortunately, the majority of real estate investors don’t take advantage of such possibilities. Some of them don’t even know how the tax system works, while others make serious mistakes with record-keeping and entity selection.

Identifying the most frequent mistakes will allow you to learn how to increase your profits. By working with experienced tax attorneys, you can come up with an effective plan.

Inadequate Understanding of Passive Activity Provisions

An important reason why investors miss out on some crucial tax deductions is the inability of taxpayers to understand the provisions contained in the passive activity rules as provided in Section 469 of the Internal Revenue Code.

According to the IRS rules, a rental real estate is deemed a passive activity, thus influencing how income and loss from a rental is handled.

Most investors believe that if the income from rental property results in a loss, they will have the ability to claim a deduction of such loss from their salary or active businesses.

Unfortunately, this may not be always possible due to the following general rule:

• Losses from rentals may be used to offset income from other passive activities.
• Such losses are not deductible from income derived from a W-2 job or an active business.
• Unused passive losses are carried forward into future years where they could be used.

Not Qualifying for Real Estate Professional Status (REPS)

Most real estate investors have heard about Real Estate Professional Status (REPS); however, very few investors really know how to qualify.

Being able to claim REPS is probably one of the best possible tax deductions an investor can receive because by qualifying, investors can classify their rental activities as non-passive in some cases. As a result, it will become easier to claim rental losses against ordinary income.

The IRS will require from an investor to:

• Work for at least 750 hours in real estate each year.
• Spend more than 50 percent of total work time on real estate businesses.
• Be involved in the management or operation of the real estate business in a material manner.

It is not easy to meet such criteria without proper documentation and participation.

It is important to understand that many investors make a mistake and believe that by having several rental properties, they are eligible for claiming REPS. It is not true and not meeting all IRS requirements, investors might miss some valuable deductions.

It is important to plan and document everything properly during the year.

Bad Records May Mean Loss of Legitimate Deductions

Where even qualifying deductions may be disallowed because of bad record-keeping during an IRS audit.

Record-keeping is used to prove that costs are indeed legitimate, and business related.

Some of the most common problems with record-keeping are:

Failure to Track Time for REPS

Individuals interested in achieving Real Estate Professional Status need to keep good records documenting the number of hours they have put into work through the year.

There are plenty of ways one can document participation – calendars, appointments, project management systems, electronic tracking of time, etc.

Not Saving Receipts and Supporting Information

Each deductible expenditure needs to have a supporting document.

Some examples include:

• Repairs invoices for property
• Contractor payments
• Utilities
• Mortgage interest
• Premiums on insurance
• Management fee for property
• Travel costs associated with rental property.

Without proper documentation, valid deductions may not be deductible.

Inadequate Record Keeping of Material Participation

Another vital criterion of the IRS for many tax advantages is material participation.

Investors need to document their involvement by keeping records of meetings attended, decision-making concerning maintenance, communication with tenants, inspections, and other management activities.

Effective record keeping will not only help secure tax advantages but also give one peace of mind during an IRS audit.

Not Considering Advanced Tax Techniques

There are many people who think only about simple deduction methods without considering advanced tax methods, which can lead to significant savings.

Advanced tax techniques usually involve expert advice and can help increase your after-tax return greatly.

Cost Segregation Study

In a cost segregation study, you identify the parts of the building that can be depreciated on a shorter schedule than residential or commercial property.

Thus, by increasing the amount of depreciation expenses, you decrease taxable income.

Bonus Depreciation

Bonus depreciation used along with cost segregation might help investors to claim a large percentage of deductions for eligible property improvement expenses right away rather than over several years’ time.

As much as tax regulations keep changing, the use of bonus depreciation continues to be of importance to many investors.

Timing of Expenses

Expenses related to repairs and maintenance, capital improvements, and equipment purchases might affect an investor’s taxable income.

Planning the expenses before the end of the year could help reduce taxable income when it’s very high.

Investors should not base their financial decisions on business considerations alone; they have to plan expenses according to their tax plans as well.

Choosing the Wrong Business Entity

The form of business through which the investment property is held will influence taxes, liability, and financial planning.

Investors often buy rental properties individually without considering other forms of business organization that might better meet their needs.

Some possible structures for property ownership are:

• Individual ownership
• Limited Liability Companies (LLC)
• Partnership
• S Corporation (on limited occasions)
• Estate planning trusts

All of these have different pros and cons based on issues like liability protection, financing, succession planning, taxation, and investment purposes.

Picking the wrong one can limit your flexibility and make the process more difficult.

Professional guidance can help you pick the right structure for yourself.

Overlooking Income Phase Out Guidelines

There are several tax incentives that get phased out or completely eliminated when income surpasses specified levels determined by the IRS.

One of the best examples of such phase outs is an allowance for a tax deduction that allows taxpayers to deduct rental real estate losses worth up to $25,000.

This particular deduction phases out if modified adjusted gross income goes above a certain level.

Individuals that are not familiar with this provision may make wrong assumptions concerning their deductions or savings on taxes.

Being Too Passive without Having a Tax Strategy

Many individuals buy rental properties as investments but rarely participate in the day-to-day property management of these investments.

Although passive investing does have its benefits, being too passive may mean missing out on some potential tax savings.

Having more participation in management-related tasks may help some individuals meet material participation standards.

Some examples of being actively involved are:

• Managing tenants
• Overseeing renovations
• Deciding on maintenance tasks
• Evaluating financial statements
• Coordinating contractors
• Controlling operations

How much participation is needed varies by individual.

How to Make the Most of Your Tax Benefits in Real Estate

Real estate investors who are successful do not consider tax planning as something to be done in tax season only.

In order to make the most out of tax benefits, one must:

• Be familiar with the IRS regulations on rentals, passive activities, and depreciation.
• Organize records for all expenses incurred in the business.
• Keep track of time spent in case the investor wants to have Real Estate Professional Status.
• Check periodically the ownership structure since it needs to fit your growing investments.
• Explore tax strategies such as cost segregation and depreciation.

Following these tips will help you pay less taxes and succeed in your investments.

Real estate tax is very complicated, and it changes constantly. When investors depend solely on generic tax software or basic accounting practices, chances are good that they overlook possibilities which would allow them to optimize their income even more.

We at CCN Business Consulting Advisory help real estate investors to find possible savings and prepare tax plans which fit into current regulations of the IRS.

Here is the list of services we provide for our clients:

• Real estate tax planning
• Preparation and compliance with tax
• Cost segregation planning
• Entity structure
• Real Estate Professional Status planning
• Investment tax planning

No matter whether you have one rental property or many, we will help you make the right financial decisions.

For more information, visit https://ccnbusiness.com/.

Summary

Real estate provides some of the best tax breaks to any investor, yet these are only possible with a solid understanding of the Internal Revenue Services laws and advanced planning. It is essential to familiarize oneself with the tax laws and choose the proper ownership form along with other tax planning measures in order to decrease taxes.

It is unfortunate that many real estate investors do not get full tax deductions due to their lack of understanding about passive activities and Real Estate Professional Status, as well as the lack of appropriate documentation of their income and expenses.