Investing in real estate has increased in popularity over the past 8 years becoming a popular investment vehicle, the art of buying to rent really became a broad market approach shortly after the 2008 housing crisis. Home ownership had dropped like a rock offering a new and very rewarding investment class for the average investor. While the stock market is rigged for Wall Street, buy to Rent has flourished for the small investor. Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than investing in stocks and bonds. In this article, we'll go beyond buying a home and introduce you to real estate as an investment and break out the various tax benefits.
When you own real estate you rent besides the potential for an ongoing income and appreciation, such investments offer tax deductions that can reduce the income tax on your profits. But first, what kind of real estate investor are you: a passive investor or real estate professional? In this article we'll show you how your classification could make a big difference in the number of tax breaks you get.
If you spend the majority of your time in the real estate business as a real estate professional, your rental losses are not passive. This means that your losses are fully deductible against all income, passive and non-passive. Otherwise, your losses are passive and only deductible up to $25,000 against your rentals' income (deduction phases out if your modified adjusted gross income (MAGI) is between $100,000 and $150,000). However, losses of more than $25,000 can be carried over to the following year.
The IRS defines a real estate professional as someone who spends more than one-half of his or her working time in the rental business. This includes property development, construction, acquisition and management. You must also spend more than 750 hours per year working on your real estate rental properties. The key to this is “keep a journal,” especially while holding your regular 9-5 job. Just because you want to call yourself a professional the IRS wants to see some evidence.
Common Income Sources
Rental Income:Money you receive for rent is generally considered taxable in the year you receive it, not when it was due or earned; therefore, you must include advance payments as income.
For example, suppose you rent out a house for $1,000 per month and you require that new tenants pay first and last months' rent when they sign a lease. In this case, you'll have to declare the $2,000 you received as income, even though a $1,000 of that $2,000 covers a period that might be several years in the future.
Tenant-Paid Expense: When your tenant pays an expense for you this is considered are considered income. This would include, for instance, an emergency repair on a refrigerator a tenant has to have done while you are out of town. You can then deduct the repair payment as a rental expense.
Security deposit: Security deposits are not taxable when you receive them if the intent is to return this money to the tenant at the end of the lease. But what if your tenant does not live up to the lease terms, what do you have to report? For example, suppose that you collect a $500 security deposit and then your tenant moves out and leaves holes in the walls that cost $400 to repair. You can deduct that amount from the security deposit during the year that you return it. At that time, though, you must include the $400 that you used to repair the wall as income. You will also be able to show the $400 as a deductible expense.
Repairs Vs. Improvement: Rental property owners may assume that anything they do on their property is a deducible expense. Not so, according to the IRS.A repair keeps your rental property in good condition and is a deductible expense in the year that you pay for it. Repairs include painting, fixing a broken toilet and replacing a faulty light switch. Improvements on the other hand, add value to your property and are not deductible when you pay for them. You must recover the cost of improvements by depreciating the expense over your property's life expectancy. Improvements can include a new roof, patio or garage.Therefore, from a tax standpoint, you should make repairs as the problems arise instead of waiting until they multiply and require renovations.
Common Deductions
Mortgage Expenses: Expenses to obtain a mortgage are not deductible when you pay them. These include commissions and appraisals. However, you can amortize them over the life of your mortgage.Once you start making mortgage payments, remember that not all of the payment is deductible. Since part of each payment goes toward paying down the principal, this amount is not a deductible expense; the portion paid toward interest is deductible. Your mortgage company will send you a Form 1098 each year showing how much you've paid in interest throughout the year. This is deductible. Also, if a part of your payment includes money that goes into an escrow account to cover taxes and insurance, your mortgage company should report that to you as well.
Travel Expenses: Money you spend on travel to collect rent or maintain your rental property is deductible. However, if the purpose of the trip was for improvements, you must recover that expense as part of the improvement and its depreciation.
You have two choices on how to deduct travel expenses: the actual expenses or the standard mileage rate. You can read more about the IRS's requirements and current mileage allowance in Publication 463.
Other Common ExpensesIn addition to repairs and depreciation, some of the other common expenses you can deduct are: Insurance, taxes, lawn care, tax return preparation fees, losses from causalities (hurricane, earthquake, flood, etc.) or thefts.
Condominiums and Cooperatives: If you own a rental condominium or cooperative, each has some special rules.
Condominiums: With a condominium you might pay dues or assessments to take care of commonly-owned property. This includes the building structure, lobbies, elevators and recreational areas.When you rent your condominium, you can deduct expenses, such as depreciation, repairs, interest and taxes that relate to the common property. However, just as with a single-family rental, you cannot deduct money spent on capital improvements, such an assessment for a cabana at the clubhouse. Instead you must depreciate your cost of any improvement over its life expectancy.
CooperativesExpenses: These expenses incurred because you rent a cooperative apartment are deductible. This includes the maintenance fees paid to the cooperative housing corporation. Capital improvements are treated differently - you cannot deduct the cost of the improvement, nor can you depreciate it. You must add the cost of the improvement to your cost basis in the corporation's stock. This will reduce your capital gain when you sell the apartment
Keep Good Records, Under the IRS's Schedule E there are spaces for numerous categories of expenses. Therefore, the IRS gives you flexibility in the items you can deduct. But be prepared to back up your claim, and be sure to break out expenses that are for repairs and maintenance from those that are capital improvements. Remember, money you spend on improvements could reduce your tax liability when you sell your property.
In addition, if you claim to be a real estate professional, you should keep supporting documentation (appointment books, diaries, calendars, logs, etc.) to prove your active participation and the time spent on your properties each year.All in all, there are quite a few types of deductions available to real estate investors and it pays to know which ones you qualify for.
Income-producing properties are also purchased by individual investors in the form of smaller apartment buildings, duplexes as well as single family homes or condominiums that are rented out to tenants.
In the context of portfolio investing, real estate is traditionally considered an "alternative" investment class. That classification no longer registers. You can buy a portfolio of stocks and bonds that has very high volatility and risk or a portfolio of rental properties with relative low volatility and risk.
One of the main differences between investing in a piece of real estate as compared to stocks or bonds is that real estate is an investment in the "bricks and mortar" of a building and the land it is built upon. This makes real estate highly tangible, because unlike most stocks you can see and touch your property. This often creates substantial pride of ownership, but tangibility also has its downside because real estate requires hands-on management. You don't need to mow the lawn of a bond or unplug the toilet of a stock! You also don’t have to worry if your stock is being manipulated or crushed on earnings. Comps in your neighborhood reflects on value as does cap rates.
Leverage
Real estate gives an investor one tool that is not available to stock market investors: leverage. If you want to buy a stock, you have to pay the full value of the stock at the time you place the buy order or if you are buying on margin, the amount you can borrow is half the market price. Most investment real estate loans can require as little as 20% down. his means you can control the whole investment property and the equity it holds, by only paying a fraction of the total value. Of course, your mortgage will eventually pay the total value of the house at the time you purchased it, but you control it the minute the papers are signed.
If you look at each property you’re considering as you would a common stock you will have a very clear idea what you want and where you want to own it. Value each purchase as you would the purchase of Apple or GM. Consider a “Cap Rate” just as you would consider a dividend on your stock investment. You wouldn’t buy a stock from your broker if you didn’t think there was any chance of appreciation, so why buy real estate without the upside?
