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

Question

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 · Answer

@Bobby BalowHi 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.

Basit Siddiqi · Answer

@Bobby BalowWhat did your accountant say when you asked him this question? The fact that he did your taxes(means he knows your income level, what changed between 2020 and 2019), he would likely best suited to answer your question.There are hundred's of reasons that can cause an increase in taxes, especially if your income is above $150,000.1. You have positive rental cash-flow from the rentals. This would cause your rental income to increase(where there is no withholding) and then cause your taxable income/taxes to increase2. The withholding from your employer decreased.3. Your income level is above the threshold for Net Investment Income Tax which kicks in another 3.8% tax on investment incomeetc, etc, etcThe job of the accountant is to explain this to you and see if there are ways to mitigate it.

John Duston · Answer

@Bobby BalowYour tax return should have a "Two Year Comparison" take a look at that to see what changed your taxes.Remember, taxes grow exponentially, not linear. (More income gets taxes and at a higher rate) Just because your tax went up doesn't mean your CPA did anything wrong.As a CPA myself, my least favorite part of the job it going through the details of showing people why thier taxes are going up and are going to keep going up but I always do it. Ask yours went your tax went up .

Bobby Balow · Answer

Wow thanks everyone for all the great comments and suggestions! I'm learning so much about this process and feel better now that higher taxes = making progress and not "leaving something out" 🙂

Shadonna N. · Answer

Since you have a W2, are you considered a passive investor and limited by the amount you can deduct?

Dan Schwartz · Answer

"I bought some real estate" is not some magic spell that makes taxes go away, like so many like to assume.It is rather likely that the income generated by the real estate will generate a tax liability (in the current year, at least), but for the most part, the rental income has zero bearing on your W-2 income (should you have any), your interest and dividends (should you have any), your other businesses (should you have any), your non-real estate investment capital gains and losses (should you have any), and your personal deductions (should you have any). Any one or more of those things can cause you to have a higher or lower tax bill in any particular year.Just because Robert Kiyosaki famously called rental real estate "zero tax income," doesn't mean income taxes are zeroed out, globally.Here are the instructions for Schedule E: https://www.irs.gov/pub/irs-pd.... You don't have to know the ins and outs, and you can certainly pay someone for their time in preparing it and helping you manage it in current and (more importantly) future years. But you are investing in real estate and concerned about its impact on your taxes. Print out the instructions (11 pages, but you can omit page 11), read it, and highlight anything you don't understand and want to get more education on. Tax instructions are basically a choose-your-own-adventure novel. Have a baseline understanding, and you'll get far better help from professionals in the future.Good luck!

Bobby Balow · Answer

Our MAGI is much greater than $150K due to my wife and I having W2 income as well and the income from the air bnb does pretty well. We did not talk to our cpa throughout the year. We didn't realize the importance of this as we have always just filed taxes based on w2 income. This was a much needed wake up call to say the least 🙂

Ashish Acharya · Answer

I don’t think you flipped these rentals. You just rehabbed them. Flipping would increase your taxes because you have new self-employment taxes to pay, if you didn't use some tax mitigation strategy. Big picture observation: your taxes shouldn’t have increased just because you bought these rentals (unless these rentals gave you huge positive cash flow even after depreciation during the first year). The basic deduction concepts are already mentioned above by other members here. Are you guys tax’s real estate professionals or have MAGI less than 150k? If no to both, your losses from this rental wouldn’t help decrease your taxes anyway. If tax mitigation is your goal, your real estate investments has to be planned in such a way that these goals are achieved, to the extent possible. Did you talk to a tax advisor on the your activities through out the year?

Jody Sperling · Answer

There are too many variables in each situation to say whether your tax professional did everything he or she could to reduce your taxable income through depreciation, improvement write offs and governmental administration changes, but you are asking the right question.My wife was an accountant before leaving the professional world to focus on our rental business and our children. She still prepares our taxes but not a year goes by when she doesn't reach out to an old colleague to ask questions on how we can reduce our base using our assets.Paying several thousand dollars more in taxes after purchasing three rundown rentals and spending the kind of money you did should have given you a pretty major tax relief, but it is key to consider which of the repairs should have been written off versus which should be capital improvements, etcetera. I'm not an accountant, and this isn't advice, but as I said, you're asking the right questions and there's no harm in trying a new accountant next year.Best of luck!

Wayne Brooks · Answer

I assume you didn’t really mean “flipping”. If they were vacant, costs to make them ready for rent aren’t immediately expensed, but depreciated.