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PostHeaderIcon Rental Real Estate Taxation Basics

While I continue to fret over my “about me” page, one of the things people ask me is, “What is your specialty?”  Over the course of my 18+ year career in tax, to a certain extent, I’ve done it all.  I’ve worked on billion dollar bank and insurance companies and large multinational manufacturing companies all the way to the businesses that bring their receipts in a shoe box.  Still, for most of the past ten years I’ve been immersed in real estate.  They’re not the only clients I work on but it’s become a niche I’ve embraced.  This includes big real estate (I spent over five years in the tax department of a publicly traded REIT) to local real estate working with investors mostly in the Detroit-metro area.  You’ll also find that a lot of the content on this site is real estate related.

One of the things I haven’t touched on in a post is the taxation basics of rental real estate.  If done right, rental real estate can be a great investment but when you take into consideration some of the favorable tax rules that surround it, it can definitely be something you want to look at to add to your portfolio of investments.

First off is the disclaimer. I’m going to making a lot of general statements but as always, everyone’s tax situation is unique so be sure to consult with a professional before you put any of this advice in place.

The first question I usually get asked is about entities.  I’m going to focus on just the tax implications and leave the entity protection discussion for your attorney.  If you want to buy and hold real estate, most of the time you’re going to hold it in a non-corporate entity.  If you want to read about why you probably don’t want to hold real estate in a corporation, I discussed that specific issue in a separate post.  Most of the time you’ll be dealing with a limited liability company (LLC).  If it’s a single member LLC, you’ll be reporting your rental real estate activity on Schedule E of your 1040.  If its a multi-member LLC, then the default tax form is the Partnership Return, which is Form 1065 with the specific rental activity being reported on Form 8825.

The next question I’m usually asked is “What can I deduct?”  The IRS’s general rule is an expense has to be ordinary and necessary expense in carrying on the  trade or business.    As usual they like to keep things vague but the first bucket of expenses are what I call the Big Three.  This is your interest, insurance and taxes.  Rental real estate will almost always have insurance and taxes and if there is leverage involved, you will have interest as well.  In dollar terms, those three expenses usually make up the bulk of you cash outflows.  If you hire a property manager, that is also a deductible expense.  Repairs (not to be confused with capital improvements) can also be deducted as can utilities if that’s a cost you incur on behalf of your tenants.  Costs to advertise the property are also deductible and you can also deduct your mileage if you’re making trips out to the property (within reason). You can also deduct legal and other professional fees (accounting and tax as an example) as well.

I mentioned repairs and you have to distinguish between a deductible repair and a capitalized capital improvement.  Lets use a roof as an example.  If you have someone come and patch up your roof, it’s probably something you can deduct. If you’re replacing the entire roof, that would probably fall more into the improvement category and you should capitalize it and depreciate it over its useful life.

Which leads me into depreciation.  When you buy a piece of real estate, you buy several different things.  You get a building, you get land and unless the house is gutted, you also get a lot of fixtures, pipes and wires.  You have a couple of choices when it comes to depreciating your property.  One option, although it’s usually not cost effective for single family homes, is a cost segregation study.  When you do a cost seg. study, you really break down the cost of what you’re buying and the end result is, you usually get property that you can depreciate over a shorter useful life (i.e. more depreciation expense now) versus property you can depreciate over a longer life (less depreciation expense now).  The other option is to just go with an estimate like an 80/20 split between property and land with the 80% being depreciated over 27.5 years.  You don’t get to take advantage of the quicker depreciation tables but you also have to spend less administrative time and money to break everything down.

When you prepare your taxes, the calculation isn’t that challenging but you have to make sure you fill out the form completely and accurately.  You take your rental income and subtract your cash expenses and your depreciation to come up with a net number.  If it’s a positive number, it’s either reported on your 1040 or it will flow through from your Form 1065 via a Schedule K-1.  If it’s a loss, then it gets a little trickier because the passive activity loss rules can get complicated.  I will save how and when you can take these losses for a post of its own.

Hopefully this is enough to get you started or if your already renting property, it validates what you’re doing. There are some other strategies I’d like to talk about, including ways to set things up if you own multiple properties, but this is getting a bit long and I will save those as well for a future piece.  As always, if you have questions, you can find a few different ways to contact me on my contact page or if you have a comment, feel free to leave one here.

PostHeaderIcon The New Form 1040, Schedule C

Last week we talked about Schedule E and this week it’s Schedule C.  Yes, Schedule C has some changes and they look a lot like the changes on the new Schedule E.

First up is Lines I and J.  This is the IRS’ trap to get more Form 1099 compliance.  Be very careful how you answer these questions because if you have a large amount of expenses like professional fees and repairs, you could be opening yourself up to a notice or having the IRS take a second look at your return.

Also new is line 1a.    This is to report income from the new Form 1099-K that reports merchant card and third party payments.  If you take credit cards or use paypal, look for your 1099-K and this is where you’ll report that income.

Also new is line 27b.  Right now it’s reserved for future use.  I’m not sure where they’re going with that one so if someone knows, feel free to leave a comment.

That’s it.  These are the first changes to these forms in a while and it gives a pretty good indication of what the IRS is on the lookout for.  Their budget is being cut so they’re looking to 1099 compliance to help them out and they’re at least making taxpayers think about the 1099 issue by answering the questions.

PostHeaderIcon Monday Tax Bits – Some Great Tax Advice

Let’s get right to it.  Taxgirl is one of the first places to go.  She’s been penning her “My Best Tax Advice Ever” pieces and she’s up to Part 2.  And in case you missed it, here’s Part 1.

Good news for procrastinators out there.  With it being Emancipation Day, tax returns won’t be due until Tuesday, April 17, 2012.  Throw in the fact that this is also a leap year and it means you have a few extra days to get your tax return done this year.  This is particularly cool for preparers and I know those extra days will come in handy.

In case you missed, I went into some of the changes on the new Form 1040, Schedule E.  If you’re a renter, you won’t want to miss this.

Extenders is the word on the street over at Congress.  With the lame and confusing two month payroll tax extension, Congress has that and a bunch of other things to take a look at preferably sooner rather then later.  Here’s the rundown on what has to be decided.

Finally, if you’re a part time or even professional gambler, here’s a decent column on tax rules for gamblers.

PostHeaderIcon The New Form 1040, Schedule E

I’ll get to how in a second, but this post ties in nicely with yesterday’s piece on Form 1099-MISC.  The IRS revamped their Schedule E, that’s attached to your Form 1040 if you have either rental properties or you own an interest in a flow through entity (LLC and S-Corporations are the big two) where you receive a Schedule K-1.  Page two is used to report your flow through entity activity and that’s largely unchanged.  Page one has new stuff on it and it’s worth examining further.

The first big change is at the very top of the form where they now ask you two questions and both relate to Form 1099 requirements.  In the famous words of Admiral Ackbar, “It’s a trap!!”  The two questions seem innocent enough but what the IRS is basically trying to do here is make sure you’re meeting the newer (although they’ve always been around, the IRS just seems to be focusing on them) rules that require property owners to issue 1099s.  If you operate your rentals under a business structure you probably should have been doing this anyway but now the IRS is on the prowl with regard to this particular issue.

The trap on Schedule E works like this.  Say you’re preparing your return in April and you get to your Schedule E.  You say to yourself, “I’ve never done 1099-MISC’s before, I’m not going to start this year plus it’s already too late,”  so you check “no” to each question.  The problem is, you’ve also reported $800 in professional fees, $1,300 in repairs and $2,000 in management fees, odds are some of those went to an LLC or a self-employed individual (you’re still not required to send corporations a 1099, we dodged that bullet when Congress repealed that provision that was in the health care law.  So by saying no to those questions AND reporting those deductions, you’ve now increased your chances of hearing from the IRS.  So beware and if you’re reading this now, either read up on (yesterday’s post is a quick primer) or talk to your adviser about getting out some 1099′s.

The other change to the schedule is line 3a.  The IRS added a line to separately report income reported on the new Form 1099-K.  If you take credit card payments or receive money from a third party network such as paypal.com and you exceed the minimums spelled out in the instructions, then you’ll get a Form 1099-K this year.  If that 1099-K is for your rental, then that’s the line where you enter that information.

So that’s the new form.  If you want more information, you can find the schedule’s instructions here.