Why Our Taxes are So High After Investing in 3 Homes?

[Bobby Balow]

Good morning everyone! I want to start by saying thank you to this amazing community! I really hope we can get some advice on our tax situation.

In 2020, we only had 1 rental at the time, but an investor in the area was cashing out and we managed to grab 3 additional rentals which needed major overhauls. We spent close to $150K buying and flipping these rentals and I was shocked to see that our taxes INCREASED by several thousands of dollars even though we made such a major investment and took on substantial debt to buy these houses (in the form of a HELOC and an additional mortgage).

Is this typical? I thought for sure we would be able to write most of this off. I'm wondering if it's time to find a new accountant that also invests in real estate that can help set us up to minimize our tax liability without affecting our ability to acquire additional loans. 

As it stands, we have 4 houses we rent, and we live in a house that has an air bnb in the basement in the Washington DC area (rentals are all in Indiana). Any help/comments/suggestions would be greatly appreciated!

[Anna Laud]

@Bobby Balow

Hi Bobby! 

So without being fully aware of your personal tax situation, it sounds like maybe some things that were able to be deducted might not have been is what you're thinking? 

Capital improvements that add value to the property are deductible over the life of the property. Capital improvements include expenses for improvement to the property, such as a new roof, new siding or major renovations.

Capital improvements for residential property are deductible over a 27.5-year period; Ordinary repairs required to maintain the property in good condition, such as painting, fixing leaks and replacing broken windows, are deductible in the year they are paid. 

If you spent a decent portion of this $150K on capital improvements, in theory you will be deducting them over the remaining economic life of the properties. The other portion of these improvements (ordinary)  that were more immediate in need and paid for this year would have been deducted this year. Maybe there is some confusion in capital improvements vs ordinary improvements.  

Depreciation deductions are a way to deduct the cost of the property during the life of the property as long as you own it. So with capital improvements the  depreciation is deducted over 27.5 years for residential income property. The value of the land cannot be depreciated, only the value of the improvements- which is what you're speaking of as far as a portion of your $150K goes I'm assuming.

For example, a residential property costing $400,000 has a land value of $100,000. The value of the improvements, $300,000 in this case, is deductible over 27.5 years. $300,000 divided by 27.5 yields a deduction of $10,909.00 every year. This amount is prorated in the year the property is purchased. The depreciation deduction allows investors to recover the cost of the initial investment over the life of the property- hence a 'hold' portion of a buy & hold investment vs a flip and the long term recouping. 

It's more specific than this breakdown, but basically rehabbing a bathroom (think attached/modified structure) would be a capital improvement deducted over time, but something like the cost of the toilet would be deductible this year as 'ordinary'  and therefore maintenance. 

But one thing it does seem would be beneficial would be to use an accountant that's familiar with every possible way to deduct your expenses now- someone who invests themselves or works with investors regularly- there may be things that qualify for expenses vs capital improvements that weren't accounted for. 

It really would be best it seems to get some professional CPA advice to clarify if any deductions were missed and to be clear on your full tax situation from someone who's familiar with real estate investing, as well as taking a closer look at what was (from your records) an ordinary repair/expense vs a capital improvement.

It might be best to sit down with them and have an overall plan or idea as to what you could see over the next 5,10,15 years etc as far as deductions go, combined with your clarification on expenses and rental income. This way you could have more of a plan in terms of projected ROI and perhaps not have any more surprises.

Hope that helps some- and I can also message you the link of another BP member/site that might have some advice or input if you'd like as they do accounting for investors. I've never used them personally, but may offer some help.