Let’s start off with some of the basics of real estate investing. Why invest in real estate? There are 3 unique advantages for real estate investing:
(1)Cash flow, money you put IN your pocket month in and month out,
(2)Appreciation, passive and/or active, and
The Three Advantages of Real Estate Investing
Cash flow all depends on a smart buy. If you bought real estate that doesn’t cash flow, it costs YOU money every month. Fix it or dump it. A real estate loser is not a long-term wealth strategy.
Appreciation can be passive or active. Passive appreciation occurs when the property goes up in value because ALL property in that area is going up in value. Over time, pretty much all real estate with appreciate. However, if the area is in a long-term downturn or if you paid way too much for the property to begin with, you may never have passive appreciation.
Passive appreciation is not guaranteed.
Active appreciation occurs when you improve a property, update it, fix it or change its use. The property is worth more because you did something. Active appreciation is a more certain and faster way of increasing value and allows you to charge higher rent to improve cash flow.
One of the most sought-after and misunderstood benefits of real estate investing comes from tax breaks. At a minimum, you can offset that cash flow with legal tax deductions so you don’t have to pay tax on the cash you make.
Where else can you get that? If you make income in your business, you’ll probably pay tax on it. (I say “probably” because there are strategies to pay little or no tax, but few people put those in place because it has to be planned years in advance and it might even require that you move.)
But, can you take a deduction of those real estate tax breaks against your other income?
Passive-Loss Rules for Real Estate
The tax loss from real estate is called a passive loss. At this point, we have to look at what type of real estate you have.
Long-term real estate losses are deductible against your other income up to $25K per year if your adjusted gross income (AGI) is under $100K. If your AGI is over $150K, you can’t take any of the write-off unless you are a real estate professional. If your AGI is between $100K and $150K, the amount you can deduct phases out.
If you have a vacation rental, defined as a property that has an average rental period of 7 days or less and for which substantial services are provided, the long-term passive losses do not apply.
But that doesn’t mean it’s a free-for-all!
Loss Rules for Vacation Rentals
In a recent Tax Court case (Lucero, TC Memo 2020-136), a couple owned beachfront property that they rented for an average rental period of 7 days or less. A management company rented out the property, collected the rents, cleaned the property and arranged for repairs.
Sounds good, right?
Nope. There are a couple more things that you still need to prove.
In their case, the couple did not actively participate. This is a lesser standard than the material participation that long-term rentals need to prove. Active participation is just 100 hours per year and you can spend that time supervising someone else’s work. Just make sure that you document the time!
This is an area that IRS is using audits to focus on now. If you have an AirBnB (or other type of vacation rental), pay attention! You MUST keep a log of your time to prove 100 hours of active participation.
The second issue is that you must have basis. If you hold the property inside an LLC that is just a regular flow through (partnership or Schedule E), then it will probably be easy. You’ve either bought your property with cash, a loan or combination of both.
But if you hold your property inside an LLC that has elected to be taxed as an S Corp (LLC-S) or an S Corporation, you may have a challenge. In that case, only cash will qualify as basis. If the LLC-S or S Corp borrows the money, you do not get basis for it. That does not work if the tax entity is an S Corp.
The simplest things can get complicated when it comes to taxes.
Make sure you have an expert on your side.
To find out more about taxes for your real estate investments or business, join our coaching program. If you’d like to consult with one of our CPAs or accountants, please go to Tax Help.