From house hacking your first home to listing Airbnb rentals, real estate investments are a profitable income stream.
How profitable?
Well, for instance, an Airbnb in San Diego, California can earn more $30,000 per year!
Not only is real estate investing profitable, the tax laws around real estate enhance profitability as well.
As a real estate investor, you have exclusive deductions, credits and tax strategies that can decrease your taxable income. These tax benefits are attractive to almost anyone seeking to build wealth.
The tricky part is, however, real estate tax laws are not straightforward. Thanks to a multitude of IRS code sections and consistently changing legislation, it can be difficult to self-educate on real estate tax law.
To provide a general understanding of rental real estate tax, I interviewed an expert – Ryan the Real Estate CPA.
Interview with Ryan the Real Estate CPA
Interview with Ryan the Real Estate CPARyan has provided tax consulting services to some of the nation’s largest investment management firms, hedge funds and real estate investors. Not only is he a consultant, he also understands real estate tax law as an investor himself.
Check out his response to 5 frequently asked questions about rental real estate tax.
1. How does the IRS tax rental income?
By default, rental income is taxed as passive income, although there are exceptions we will get into.
Passive Income
If your rental property involvement is not regular, continuous and substantial, the income your property generates is passive.
Passive rental real estate activity is reported on Form 1040, Schedule E.
The main benefit of passive Income is, unlike your W-2 income, it is not subject to payroll tax .
Let’s say you make $12,000 in net operating income from your rental property. While your W-2 income is subject to income tax and an additional 7.5% payroll tax, your $12,000 passive rental income is only subject to the income tax.
So, right off the bat, rental income puts you in a lower effective tax rate.
Note, however, the IRS limits passive activity losses. Passive rental real estate losses cannot offset W-2 or business income.
Business Income
Bear in mind, rental income is not always passive.
If you cook and clean for your tenants during their stay, or do any other work that is regular, continuous and substantial, then your rental income is business income.
Rental activity is reported as business income on Form 1040, Schedule C.
Although business income is subject to payroll tax, deductions such as travel and office expenses can substantially reduce your taxable income.
Not only that, as a business activity, your rental real estate loss can offset your earned income.
All things considered, the passive versus business income aspect is only a small piece of rental real estate taxation. To better understand the additional components of real estate taxation, we must separately identify Short-Term Rental Properties and Long-Term Rental Properties.
Short Term Rental vs Long Term Rentals
Short Term Rentals (STRs) are defined by the average tenant stay. The IRS says, if the average tenant stays 7 days or less, the property is an STR.
Normally, Airbnb and Vrbo properties produce STR income because tenants only stay for a weekend or a few vacation days.
On the other hand, tenants normally stay in multifamily properties and single-family homes for a substantial amount of time. These types of properties are considered Long-Term Rentals (LTRs)
For tax purposes, the main difference between STRs and Long-Term Rentals (LTRs) is that STRs are depreciated over 39 years instead of 27.5.
2. What is depreciation?
The IRS understands that real property is subject to wear and tear. As a result, they give real property an expected lifespan. The value of the property can be deducted over that lifespan.
That deduction is called depreciation.
[Note, depreciation does not apply to land. Although natural disasters do cause land to wear and tear, in general, land is everlasting.]
Commonly referred to as “tax free cash,” depreciation allows you to deduct a noncash expense against your net operating income.
Let’s say, for example, you have a $300,000 LTR that includes a building and land. The building’s assessed value is $275,000. As an LTR, you could deduct $10,000 of depreciation per year ($275,000 / 27.5 years).
If rental income was $12,000 with no other expenses, you only pay taxes on $2,000 ($12,000 – $10,000) of income instead of $12,000!
(Also, remember the passive income tax rates are lower than the rates from your day job income.)
Now, before you get excited about this tax free cash, let’s talk about depreciation recapture.
[dun. duN. DUNNN!]
Depreciation Recapture
Depreciation recapture is the government’s way of getting back the money they gave you as a deduction. It comes into effect when you sell your rental property.
Remember the $10,000 depreciation you deducted over the course of holding your rental property?
Well, before you are able to walk away with all of your rental real estate proceeds, the IRS requires you to pay depreciation recapture.
To calculate, you take the total amount of depreciation multiplied by your marginal tax rate (it is capped at 25%).
Let’s say you depreciated a property for 5 years (5 x $10,000 = $50,000 of depreciation) and you are in the 22% tax bracket. You would owe $11,000 ($50,000 x 22%) in depreciation recapture before you are able to recognize a long-term capital gain
Depreciation recapture is reported using Form 4797, Sales of Business Property.
3. How can someone qualify as a Real Estate Professional?
According to IRS Code Section 469(c)(7)(B), a Real Estate Professional (REP) must meet the following requirements:
- more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
[Don’t worry if that tax language made your head hurt. Let your CPA handle that. Fortunately, Ryan broke down the benefit of REP status in layman terms].
Qualifying as a REP allows you to report your rental real estate income as business income. As we discussed during our overview of business income, you can use the losses that are generated on your rental properties to offset your 9-5 wages and business income.
Let’s say, for example, you make $200,000 as a realtor. You also own rental properties that generate a $100,000 loss from depreciation, cost segregation and other expenses.
You can take that $100,000 real estate loss and offset your realtor income. If you were in a 32% tax bracket, you just saved $32,000!
Keep in mind, however, while that example makes it all seem so simple, you want to be very careful and work with a tax expert that specializes in real estate. These rules and qualifications are very hard to meet.
Finally, unlike passive real estate investors, REP rental income might not be subject to the net investment income tax. Special qualifications apply.
For more information on REP status, check out the American Institute of Certified Public Accountants (AICPA).
4. Can you recommend software or apps to track real estate hours and investment activity?
TSheets is a great app, or you can use google spreadsheets!
5. In what type of entity should you hold rental real estate?
I recommend you hold rental real estate in your personal name, Single Member LLCs, or Partnerships. As a real estate investor, you want your investments to “flow-through” to your personal tax returns.
Rental real estate should never be held in C Corporations or S Corporations because it creates many adverse tax consequences.
Here are two main issues to consider when real estate is held in an S or a C Corporation –
Taxable gain and loss issues
When you transfer real estate into an S or C Corporation, you can potentially cause a taxable event.
A taxable event can also be caused when you remove the real estate from the S or C Corporation.
When you have real estate in your personal name, Single Member LLC, or Partnerships, these issues do not happen.
Basis issues
When you contribute appreciating assets to an S or C Corporation, you have to do a great job of tracking what’s known as inside and outside basis. This can be complex and lead to a bunch of headaches down the road.
In Conclusion
For many of us, income tax will be the largest expense we pay over our lifetime. As a result, proper real estate tax planning can be life changing.
If you plan to incorporate real estate into your tax strategy, make sure to work with a tax advisor who has a reputable expertise and knowledge in real estate tax law.
Ryan The Real Estate CPA helps Real Estate Investors use the Tax Code as their road map to wealth. He is a CPA with an accounting and finance degree and is currently doing a combination of house hacking and short-term rental investments onto his way to financial freedom! You can follow him on Instagram and Twitter @LearnLikeaCPA.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.
