Look Out! Tax Traps Ahead

Perhaps one shouldn’t be surprised that real estate investors fall into the same frustrating tax traps again and again. Real estate burdens investors (especially new investors) with some tricky tax accounting that can cost you money in the long run. By knowing the different laws and regulations ahead of time, you can plan for these tax traps.

Just because someone else makes these mistakes, doesn’t mean you need to. You just need to know where the traps are so you avoid them. Luckily for you, we compiled a list. Here are the biggest real estate tax traps you don’t want to fall into:

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.

This sounds like a win… 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.

You can 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.

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, but often you can’t. 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 investors can draw, say, $20,000 from their IRA or 401(k) to fix up some rental. They figure that they will be able to write off the $20,000 as a tax deduction in the year the improvements are made. 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.

Missing the Section 121 Exclusion

Here’s the final tear-jerker. It happens quite frequently, someone decides that rather than selling their principal residence when they get a 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 filing a joint return). By converting a principal residence to a rental property, you turn tax-free gain into a taxable gain if you don’t sell the property in the first three years.

Two quick notes about mixing up the Section 121 exclusion. If you don’t have an appreciation in your old principal residence, you’re not losing any benefits from Section 121 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.

These tax traps sneak up on real estate investors every year. It’s important to know where your money is going and what will give you the most profitable return in the end. Understand the different tax laws so that you can make your investment worth it.