Too often, I hear investors say that they can’t get any tax benefits from real estate investing because they can’t claim real estate professional status. Here are a few common misconceptions:
- I cannot claim my home office or car expenses because I am not a real estate professional.
- I cannot claim bonus depreciation because I am not a real estate professional.
- I cannot do a cost segregation study because I am not a real estate professional.
- I cannot deduct my real estate education expenses because I am not a real estate professional.
- I lose out on my rental tax losses because I am not a real estate professional.
All of these statements are incorrect.
Whether an investor is a real estate professional or not, it doesn’t change their available tax write-offs. As such, an investor may be able to take a tax deduction for their home office or the business use of their car, regardless of whether they claim real estate professional status. If claiming bonus depreciation or doing a cost segregation can help reduce taxes, an investor who is not eligible to claim real estate professional status can still utilize these tax strategies.
The difference between an investor who is a real estate professional versus one who is not comes down to the way net tax losses are treated for tax purposes. All investors who own rental properties can use expenses and depreciation to reduce taxes from rental income. However, if you have more expenses than you do passive income, there is a set of rules that determines whether and when you can use those excess losses to offset income from other sources, such as your W-2.
Dreading tax season?
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Is real estate professional status important for every investor?
Absolutely not. There are many investors who are not even impacted by the passive loss limitations. For example, if you are a landlord, your total adjusted gross income (AGI) is under the $100,000 threshold, and your rental tax losses for the year are under $25,000, you can generally utilize these net losses to offset taxes from W-2 and other types of income.
For these investors, the real estate professional designation is not really relevant since they may be able to use all of their losses already and not be subject to the passive loss limitations. As long as your total AGI is under $150,000, you may still be able to use part of your rental losses during the year to offset taxes from your W-2 and other income.
Let’s go over the basics.
In general, if your AGI is $100,000 or less each year, you can use up to $25,000 of excess rental losses to offset your other income. If your AGI is between $100,000 and $150,000, then you can only use part of your excess losses to offset your other income.
If your AGI is more than $150,000, then you generally cannot use any of the excess real estate losses to offset taxes from your other income. These excess losses are called “passive losses” and are carried forward to offset rental income, capital gains on the rental property, or other passive income in future years.
What if your income is higher than $150,000?
What if your total AGI is higher than $150,000? Does it mean that there are no tax benefits to investing in real estate? Not at all. Even for passive investors who cannot claim real estate professional status, there can still be some significant tax savings to real estate investing.
Let’s go over an example of Mike. Mike works full time at his W-2 job and makes $250,000 in income. Between federal and state taxes, his tax rate is close to 45%.
Mike invests in some high-performing rentals, and his profit and cash flow from the rentals is $50,000 for the year. After utilizing some tax strategies like home office, car deductions, bonus depreciation, and cost segregation, Mike’s taxable rental income can be brought down to zero.
This means for the current year, Mike pays zero taxes on that $50,000 of rental profit received. So effectively Mike had $300,000 of total income during the year ($250,000 from job and $50,000 from rentals). Although Mike is still paying taxes on his W-2 income, Mike pays zero taxes on the income from his rentals this year. He can utilize all of that to reinvest and continue to grow his portfolio. All of this is possible regardless of whether Mike is able to claim real estate professional or not.
Cashing out of a large real estate gain with minimal taxes
Here is another example of how an investor can save on taxes without qualifying as a real estate professional. Ben and Mary both work full-time and have an income of over $450,000. They have been investing for a few years and have built up a portfolio of several rentals across a few different states. Although the properties have generally performed well over the years, Ben and Mary have been good about capturing and maximizing their rental deductions and have generated about $45,000 of passive losses that they are carrying forward into this year.
With the current market being so hot, Ben and Mary have decided to sell one of their rentals. They feel that this is the peak of the market, and they are excited to cash out of this property. The issue is that although they are able to sell this property for a pretty significant gain of over $100,000, they are not interested in doing a 1031 exchange to defer the taxes. Their preference is to keep the cash for a while and reinvest it later on when the market cools a bit.
For them, it makes more sense to wait to buy until the prices come down a bit, rather than use a 1031 exchange to quickly get into another deal where they may end up overpaying on a property. The potential issue is that without a 1031 exchange, the taxes on this transaction may be fairly hefty.
Here is where all the years of maximizing their rental tax write-offs come in handy. On the $100,000 of taxable gain on the sale of this one property, Ben and Mary are able to use all of their $45,000 of passive loss carryforward from the other properties in their portfolio to reduce the taxes. In addition, Ben and Mary worked with their tax advisors to implement a cost segregation study on one of their other newer rentals. The cost segregation study accelerated an additional $55,000 of depreciation into the current year. As a result, they were able to sell the rental with essentially zero taxable gains to pay taxes on.
- Capital gains from sale of rental: $100,000
- Total passive loss carryforwards: -$45,000
- Accelerated depreciation: -$55,000
- Effective capital gain: $0
Ultimately, Ben and Mary were able to sell the rental, walk away with the cash, and pay zero taxes on this transaction currently. This strategy saved Ben and Mary over $32,000 in taxes this year. All of this was possible even though Ben and Mary never claimed real estate professional status and did not utilize a 1031 exchange.
Turning lemons into lemonade
It would not be fair to only talk about success stories in real estate investing. Even in not-so-successful stories, there are some silver tax linings to be found.
For an investor who has passive loss carryforwards, these can generally be used to offset W-2 and other types of income in the year the investment is disposed of. Let’s go over an example of Bob.
Bob purchased a rental several years ago. It was his first venture into real estate, and he was not trying to go after the best deal in town. He was mainly looking to get his feet wet and was eager to get into his first deal. In his first years, Bob incurred quite a bit of a loss on the rental property. Between lots of unanticipated repair costs and bad property management, Bob racked up a pretty significant loss.
By utilizing some tax strategies to maximize his other tax deductions, Bob had close to $35,000 of tax losses on his tax return. Since Bob had a high W-2 income from his day job and he was not able to claim real estate professional status, his rental losses were subject to the aforementioned annual passive loss limitations.
With the knowledge that Bob gained from this first deal, he felt it was finally time to sell his rental property and re-position his money into better deals. The good thing was that Bob would at least break even on the sale. The upside of this not-so-good investment was that in the year that he sold this rental property, the $35,000 of passive rental losses carried forward were finally able to be freed up.
As a result, Bob was able to use the $35,000 of passive losses to offset taxes from his W-2 and other income. Since Bob’s high income puts him at a 45% tax rate, he was able to increase his tax refund by close to $16,000. For Bob, his first venture into rental real estate was not a huge success. However, he felt that he learned a lot that he can apply towards his future deals and was happy that this brought him a little bit of tax relief.
The popularity of short-term rentals has exploded in the past few years. For many investors, turning a property into a short-term rental doesn’t just increase cashflow, it may also significantly increase their tax benefits as well.
For most short-term rental investors, there can be some significant start-up costs associated with the property, such as purchasing appliances, furniture, and fixtures. Many of these items may be eligible for faster tax write-off using strategies such as bonus depreciation to accelerate these deductions into the first year of operation.
For short-term rentals, the IRS has a slightly different set of rules than those of long-term rentals. Those can sometimes be a big benefit for investors. An investor may be able to use their tax losses from their short-term rentals to offset taxes from W-2 and other income even if they do not qualify as a real estate professional during the year. For short-term rental investors, if material participation requirements have been met, the net rental losses from the short-term rentals may be eligible to offset taxes from W-2 and other income. Let’s go over an example of Amber.
Amber works full-time and does not have enough hours to qualify as a real estate professional with the two out-of-state long-term rentals that she owns. Lately, Amber has seen her fellow investors make a killing in short-term rentals and has decided to try it out for herself.
She loves interacting with people. One of her favorite parts of being a short-term rental host is connecting with guests who travel to her city from all over the world. The property is local to Amber, and she decides to self-manage the property in order to keep costs low.
Based on the activities that Amber performs for this short-term rental, she can prove that she materially participates in this property. As a result, Amber can use any net rental losses from the short-term rental to offset taxes from her W-2 and other income. Although the property had great cash flow that year, Amber was able to maximize her tax deductions using strategies such as income shifting, bonus depreciation, and cost segregation to create a large tax loss of $80,000 for the short-term rental.
Because she can show that she materially participated in the short-term rental, Amber was able to use this loss to offset taxes from her W-2 income, even though she didn’t qualify as a real estate professional. Keep in mind though that any losses from her long-term properties may still be subject to passive activity loss rules.
Alternatively, for investors who are passively investing in short-term rentals that are generating tons of cash flow, it may be possible to use any passive losses from the long-term rentals to offset taxes from the short-term rentals.
Don’t make this mistake
Many higher-income investors don’t track their expenses to maximize their write-offs simply because they do not see an immediate tax benefit due to the limitations of rental losses. However, it is important to understand that these losses do not expire and you never lose them.
Even if you are unable to use your net rental losses this year to offset your W-2 and other income, it is not the end of the world. You do get to carry those losses into future years to offset taxes from future rental income, capital gains from the sale of rentals, and taxes from other passive income outside of real estate.
If all else fails, any passive rental losses will become an ordinary loss to offset all types of income once you eventually dispose of the investment. It is extremely important to understand that rental income is taxed at your ordinary tax rates.
So if you do not maximize your rental write-offs, any taxable rental income will be added to all of your other income and taxed at your marginal rate for that particular year. This is why it is extremely important to make sure that you maximize your legitimate tax deductions regardless of whether you are claiming real estate professional status or not.
Make sure that you are taking the right steps today so you are set up to protect yourself from future tax increases.
If you want to understand how to save on taxes but are unsure where to start, consider checking out our mini-course Jumpstart Your Tax Savings as a Real Estate Investor. For BiggerPockets Pro and Premier members, visit your perks/pro page for a 50% off coupon code.