How to Maximize Tax Benefits as a Real Estate Investor

Real estate is one of the few investment vehicles which allow a taxpayer to receive monthly cash flow and appreciation while claiming a tax loss on that same investment. As real estate investors, most of you may already be familiar with the various tax benefits you may be able to take advantage of under the depreciation rules allowable by the IRS. Although the tax benefits of real estate investing are great, there are some limitations to taking real estate losses on your tax returns. Generally, an individual can deduct up to $25,000 of rental real estate losses per year on their tax return to offset against all their other income. However, if their overall rental real estate losses exceed the $25,000 limitation, additional losses are limited and can only be carried forward to be used in future years. In addition to that rule, once a taxpayer’s adjusted gross income for the year is above $100,000, then that $25,000 real estate tax deduction starts to get limited. For taxpayers whose income is above $150,000, they are generally not able to take a tax deduction for rental real estate losses at all. 

Before you get too discouraged, there is a loophole: If an individual qualifies as a “real estate professional” under the eyes of the IRS, the limitation of an investor’s ability to utilize real estate losses to offset other taxable income is eliminated. As such, if you or your spouse qualifies as a real estate professional, then you would be able to take an unlimited amount of tax losses on your real estate investment regardless of your income level.

To give you an idea of how powerful this concept is, let me give you an example of a common scenario. John Doe is an attorney who makes around $180k per year. He and his wife own a couple of apartment buildings that generated cash flow of $50k per year. For tax purposes, the depreciation benefits of the apartment result in a tax loss of $50k per year for John and his wife. Without qualifying as a real estate professional, John is unable to benefit from the real estate tax loss of $50k this year. As such, he pays taxes at 25% resulting in $45k of a tax payment to the IRS. However, if John or his wife were able to qualify as a real estate professional, then he would have been able to offset the $180k of income he earned with the $50k of real estate losses from his apartment investment and save ~$12,500 taxes for the year. 

Now that you see the powerful tax benefit of being designated a real estate professional, the next question naturally is: what is a real estate professional? Real estate professional, as defined by the IRS, actually has nothing to do with whether you are a licensed real estate agent or broker in your state. It has nothing to do with your education, professional licenses that you hold, or what type of business you are in. Rather, the IRS determines real estate professional status based on a set of different criteria, which involves the type of activity that the taxpayer does doing the year for the properties, as well as the amount of time spent on such activities during the year.

Simply put, the taxpayer (or spouse) needs to meet the two following criteria in order to qualify for the tax benefits of being a real estate professional: 1) Spend more time in real estate activities than other “non-real estate” business activities combined, and 2) Spend at least 750 hours per year in real estate activities. There are a multitude of activities that an investor does which count towards the real estate professional status. Here is a short list of some of those qualifying activities:

1) Buying and selling properties
2) Renting, operating and managing properties
3) Leasing and brokering
4) Meeting with agents and brokers
5) Meeting with property managers
6) Meeting with prospective tenants
7) Meetings with your real estate coach
8) Activities related to development or redevelopment
9) Actively managing any reconstruction or improvement projects
10) Inspecting (monthly, annually, etc) your properties
11) Approving monthly expenditures
12) Analyzing potential deals
13) Physically searching and viewing potential properties
14) Actively managing any direct mail campaigns
15) Speaking to prospective sellers or investors

With all the above activities that can count towards qualification for the real estate professional tax benefits, there is a lot of room for strategic planning. The main thing to keep in mind in trying to qualify for the real estate professional status is planning ahead and documentation. In conclusion, if you will be using real estate as one of your wealth vehicles, get together with your CPA and identify a plan of action that you may be able to take in order to qualify for the real estate professional status and maximize the tax benefits from your investment properties.

Copyright © 2013 by Amanda Y. Han, CPA
KEYSTONE CPA, INC.   Maximizing Profits & Increasing Wealth
www.keystonecpa.com

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