Tax Traps for New Real Estate Investors

Perhaps one shouldn’t be surprised that new real estate investors fall into the same tax traps again and again. Real estate burdens investors—especially new investors—with some tricky tax accounting.

But just because some other newbie makes these mistakes, that doesn’t mean you need to. You just need to know where the traps are so you avoid them. And here are the biggest real estate tax traps you <i>don’t</i> want to fall into:

Tax Trap 1: Passive Loss Limitation

On paper at least, real estate often loses money. Even if the rent pays the mortgage and the operating expenses, the books still show a loss because you get to write off a portion of the purchase price through depreciation each year.

If a rental house that cost $275,000 breaks even on cash flow, for example, you might also get a $10,000 annual depreciation deduction. If your marginal tax rate is 28%, that depreciation should save you $2800 annually.

Sounds sweet, right? Well, it is—or should be. Except that the U.S. Congress labeled real estate investment a passive activity and said that, except in a couple of special circumstances, you can’t write off passive activity deductions unless overall you show positive passive income.

This passive loss limitation rule means that many real estate investors don’t get to use tax 

saving deductions from real estate—or least not annually.

Two loopholes, courtesy of Congress, do exist that let you write off deductions from real estate even if overall you show a loss from real estate investing. If you’re an active real estate investor with adjusted gross income below $100,000, you can write off up to $25,000 of passive losses annually. (If your income is between $100,000 and $150,000, you get to write off a percentage of the $25,000. Ask your tax advisor for the details.)

Here’s the second loophole: If you’re a real estate professional, Congress says the passive loss limitation rule doesn’t apply to you when it comes to real estate. A real estate professional, by the way, is <i>not</i> someone who’s licensed as an agent or broker. The law instead creates a time-based test: A real estate professional is someone who spends at least 750 hours a year and more than 50% of their time working as a real estate agent, broker, property manager or developer.

Tax Trap 2:  Capitalization of Improvements

The next mistake that new real estate investors make? Thinking they can write off the amounts they spend to improve the property. Sometimes you can. Often you can’t.

Here’s why: Any expenditure that increases the life of the property or improves its utility needs to be depreciated over the next 27.5 years (if the property is residential) or over 39 years (if the property is nonresidential).

You can’t, therefore, write off the money spent improving or renovating a house—except through depreciation.

I’ve seen new real estate investors in tears about this wrinkle. Some investor draws, say, $20,000 from his IRA or 401(k) to  fix up some  rental. He figures he’ll be able to write off the $20,000 as a tax deduction in the year improvements are made.

No way. Instead, he’ll have to write off the $20,000 at the rate of a few hundred bucks a year over the next three or four decades.

The trick with renovation—if you want to call it that—is to keep the property well maintained as you go. Repainting, new carpeting, general repairs—these items should all be all deductions in the year of expenditure (er, subject to the passive loss limitation rule discussed as the first tax trap.)

Tax Trap 3: Missing the Section 121 Exclusion

Here’s the final tear-jerker. And I see it several times a year. Someone decides that rather than sell their principal residence when they “move up” to a larger new home, they’re going to turn the original home into a rental.

This is a disastrous decision most of the time because of Section 121 of the Internal Revenue Code . Section 121 says that if you’ve owned a home and lived in a home for at least two of the last years, you won’t pay any tax on the first $250,000 of gain on the sale ($500,000 of gain in the case of someone who’s married and filing a joint return).

By converting a principal residence to a rental property, you turn tax-free gain into taxable gain if you don’t sell the property in the first three years.

Two quick notes about goofing up the Section 121 exclusion. If you don’t have appreciation in your old principal residence, you’re not losing any Section 121 benefit by converting to a rental.

Second, if you do have a lot of appreciation in your old principal residence and want to use that equity to acquire a rental property, consider this: Sell the old principal residence when you move out so the gain is excluded from taxable income. Then use the tax-free proceeds to purchase another rental—perhaps even the house next door.

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