Many people invest in real estate for its enormous tax benefits. Unfortunately, too many investors squander their potential tax savings by following bad advice or making rash decisions. In this article, we’re going to share six of the best real estate tax strategies and tips every investor should know about. Keep reading to learn when to create a real estate LLC, the pitfalls of S corporations, and how to treat active and passive income on your tax return!
Summary:
The terms active income and passive income are thrown around, but it’s crucial to understand them from a tax perspective, as the Internal Revenue Service (IRS) wants all gains and losses kept in their appropriate columns. You can’t use passive losses to offset active income, nor active losses to offset passive income!
Active income is money you earn by participating in your real estate business. It typically involves more time and effort than passive income and is subject to higher taxes in the short term. Common types of active income include:
Passive income is money you earn without actively participating in real estate. You can earn passive rental income through the following strategies:
If you flip a house, for example, the income you earn is subject to federal, state, social security, and Medicare taxes. Compare this to a long-term rental property you hold for at least one year, which is not subject to social security or Medicare taxes (but is subject to long-term capital gains taxes down the road).
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Many investors move their rental properties into S corporations or LLCs taxed as S corps to reduce their tax liability, but this move can have serious repercussions.
First, putting your property in an S corp “locks” it in. If you pull the property out of the S corp later on, this will trigger a taxable event, requiring you to pay a transfer tax (and potentially sales tax). Then, putting the property back into the S corp will create a second taxable event, and you’ll pay an additional transfer tax.
What’s more, this move causes you to lose your step-up in basis. This means that when you die and pass your property on to your beneficiaries, they will be required to pay capital gains taxes on your gains and their gains when they sell (rather than only their gains). If you were to move the property into a disregarded LLC instead, you would maintain the step-up in basis!
While there are all kinds of write-offs that real estate investors can claim on their tax returns, it’s easy to mistake certain expenses as being tax-deductible!
For example, if you travel to buy a rental property, the cost of the trip doesn’t qualify for a regular tax deduction. But, if you end up buying the rental, you can add the cost of the trip to the cost basis of the property!
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An Airbnb may require one or two LLCs, depending on your involvement in the business. If someone else is managing the property or your average stay is longer than seven days, it might make sense to hold the property in a single, passive LLC.
If you’re actively managing the property or your average stay is fewer than seven days, this is one case in which you could hold the property in your passive LLC, place the operations side in an active LLC, move the active LLC into an S corp, and reap the extra tax advantages!
Having a separate real estate LLC for each property can create a management nightmare, especially if you have a large portfolio.
Not to mention, moving a leveraged property from your personal name into an LLC can violate your loan agreement and trigger the due-on-sale clause—in which case your entire mortgage balance would be due. At the same time, having multiple properties under the same LLC exposes more of your portfolio.
Instead, set all of your properties up under a disregarded LLC, and then hold each property in a land trust (for properties with four units or fewer). This is one of the best real estate tax strategies, as it will prevent the due-on-sale clause from being triggered and allow you to keep your stepped-up basis!
A mistake on your tax return could cost you hundreds of thousands of dollars, so be sure to maintain watertight records for all of your rental properties. Each property should have its own file with the details of the purchase, closing documents, and a list of repairs, maintenance, and capital expenditures.
Additionally, the best way to avoid a huge tax blunder is to work with an investor-friendly tax expert. Find a certified public accountant (CPA) who not only knows real estate but also understands your investing strategy and goals!
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