Tax Traps For New Real Estate Investors

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​ don’t 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​ not 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.
Tax Traps For New Real Estate Investors Tax Traps For New Real Estate Investors Reviewed by Henda Yesti on July 03, 2018 Rating: 5

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