Understanding Real Estate Tax Accounting

Tax accounting gets a little tricky for real estate investments. Accordingly, I want to provide you with a quick overview so you make better decisions—and so you can exploit any tax planning opportunities.

Tip: I also provide a longer e-book about real estate tax loopholes and secrets at this website that provides a much richer discussion of real estate tax accounting.

Measuring Taxable Income or Losses

Here’s the first thing to know about real estate investment tax accounting: For each property you own, you need to calculate and report the property’s taxable income. To calculate your taxable income on a property, you calculate the operating income and then (typically) you subtract a couple of additional items: the depreciation on the property and the mortgage interest on your financing. For example, earlier in the ebook, I displayed the following table to show the operating income for an example real estate investment:

	Monthly	Annually
Rental Income	$1,000	$12,000
Less: Vacancy Allowance	$50	$600
Net rental income	$950	$11,400

Expenses
Insurance	$50	$600
Property taxes	$100	$1,200
Repairs & maintenance	$200	$2,400
Total expenses	$350	$4,200

Net Income	$600	$7,200

Table 3: An example net income statement for a single family home

I also said a property like this might cost $140,000 but would require $2,000 in closing costs and then need right after closing another $2,000 in renovation costs.

I then also referenced a loan and mentioned its loan fees might equal $2,000. Though I actually didn’t provide a loan amount or interest rate, let’s say for sake of illustration that the loan balance equals $110,000 and that the loan interest rate equals 4%.

With these inputs, one gets to add three tax deductions to the operating income calculations just shown: loan interest, building depreciation, and loan fee amortization.

For example, if there’s a $110,000 mortgage loan charging 4% interest, that over the course of a year means roughly $4,400 of interest deduction. (I’m going to pretend that the mortgage only requires interest payments to keep the example simple.)

And then there’s the building depreciation. Building depreciation gets calculated by first guessing at the part of the purchase price that represents the structure. Commonly, people guess the structure equals 80%, though a better way to estimate the structure piece is by using the county assessor’s property tax percentages. But say that you are calculating depreciation for a building you spent $140,000 on plus $2,000 of renovation. In this case, 80% of the $142,000 equals $113,600. Tax laws say you can depreciate residential rental property over 27.5 years, so because $133,600/27.5 equals $4,131. That $4131 is another deduction that gets included in your taxable income calculations.

Finally, inevitably, other costs get depreciated, or spread out, over a number of years. The simple example that we’re using here doesn’t include appliances or furniture, but these items, if part of the property, would be depreciated, too. And in fact, the simple example here does include another cost that needs to be spread out over a number of years: The $2,000 loan fee which gets spread out (“amortized”) over the thirty years that loan payments will be made ($2000/30 = $67).

Table 4 shows the additional tax deductions appended to the end of the annual income statement data from Table 3. In this example, on paper, you lose $1,393 on the real estate investment. And that’s the number that gets plugged into your tax return.

	Annually
Rental Income	$12,000
Less: Vacancy Allowance	$600
Net rental income	$11,400

Expenses
Insurance	$600
Property taxes	$1,200
Repairs & maintenance	$2,400
Total expenses	$4,200

Net Operating Income	$7,200

Additional tax deductions
Mortgage Interest	$4,400
Building Depreciation	$4,131
Loan Fee Amortization	$67
Taxable Income (loss) on Property	($1,398)

Table 4: An example taxable income statement

Note: Appliances and other fixtures get depreciated over seven years, while residential rental furnishings get depreciated over five years. Tax law specifies dozens of other depreciation rules, too, but usually you don't have to worry too much about the details because the tax accounting software or the tax accountant that handles your accounting just does all this for you.

Understanding the Tax Effect of Real Estate Profits and Losses

If the bottom-line number that appears on the taxable income schedule is positive—this isn't the case in Table 4 by the way—then the investor just adds the income to his or her other income. And everything works pretty simply. If the investor's total income is high enough after taking account of adjustments, personal deductions and personal exemptions, for example, the investor may pay income taxes on the real estate profits.

If the bottom-line number that appears on the taxable income schedule is negative—meaning there's a loss like is the case in Table 4—the tax accounting gets a little tricky. Some people can use the rental property loss as a deduction on their tax returns, thereby offsetting other income. But many people can't.

And so now I'm going to go over the main rules...

$25,000 Special Allowance for Rental Property Investors

If the taxpayer's income is less than $100,000 and the taxpayer actively participates in a real estate investment (meaning the taxpayer participates in managing the property), the taxpayer can deduct up to $25,000 of special allowance real estate losses.

What this means is that as long as the taxpayer's income is less than $100,000, real estate losses like the $1,398 shown in Table 4 can be deducted on the taxpayer's tax return, thereby offsetting income, including wages, interest and dividend income, capital gains and so on.

If the taxpayer's income is $100,000 or more, then the $25,000 special allowance gets reduced by $1 for every $2 the income exceeds $100,000. Someone who makes $110,000, for example, loses $5,000 of the special allowance. So this means they can only deduct $20,000 of real estate losses. And someone who makes $150,000 can't use the special allowance rule at all because at $150,000, the “$1 lost for every $2 over $100,000” rule means the $25,000 special allowance has been wiped out.

Real Estate Professionals Rule

If the taxpayer is a real estate professional—which means someone who spends more than half of their work time and more than 750 hours a year working in real estate development, construction, property management or brokerage—then the taxpayer can write off real estate losses against their other income, including wages and investment income.

One wrinkle here, though, is that getting to the 750 hours is trickier than you might think. If you have, for example, three properties and spend 250 hours on each property, you don't pass the 750 hours rule unless you tell the Internal Revenue Service that you want to treat the work you do on all three rental properties as a single property management “activity.” (You should work with a good local tax accountant if you want to try this.)

Everybody Else Gets Limited And Delayed.

If you're not a real estate professional and can't use the $25,000 special allowance rule, you can't deduct real estate losses except to the extent you have real estate profits.

For example, if you lose $1,398 on one property but make $1,398 on another property, you can offset the two amounts.

But if you only have the $1,398 loss and no other real estate profits, the $1,393 loss isn't used until some future year when you do have real estate profits.

If you never get to use the loss—because you never make money on a single real estate deal—the loss finally gets included on your tax return when you dispose of the property. Although, I need to mention something here: you may remember that a few paragraphs ago I said that you might be able to qualify as a real estate professional by aggregating the hours you spend managing three properties. In this case, because you manage your own properties, by making an election to treat the properties as a single “activity,” you don't unlock the real estate losses until you sell the last property in the activity.

Like I said earlier, if you want to qualify for the real estate professionals rule by aggregating multiple properties as a single “activity,” you should probably work with a good local tax accountant just to make sure you don't screw things up.

Material Participation Matters

I need to make one other comment about real estate losses.

In order to deduct any real estate loss, you need to materially participate in the activity. Material participation (even if you're a real estate professional) means for real estate, practically speaking, that you meet one of the following tests:

You participate in the activity more than 500 hours a year, or
You are the only person who participates in the activity, or
You spend more than 100 hours in an activity but nobody else participates more, or
You spend more than 100 hours in a single activity and you can add up more than 500 hours of participation in multiple activities, or
You've meet a material participation test for an activity for at least five of the last ten years, or
You've spent more than 100 hours on the activity and your participation is regular, continuous, and significant.

These kinds of mind-numbing rules may make you want to pull your hair out. But probably you won't be restricted from taking a real estate loss because of failing to materially participate if you're actively involved in a rental property short sale investment.

The people who fail the material participation test “flunk” because they're involved only tangentially in a real estate deal. You should, in the case of a short sale property, find you've got more than enough material participation under one or more of these rules as long as you haven't delegated all the work to someone else.

Repairs, Maintenance and Improvements

As we near the end of this little e-book, I want to provide a short discussion of accounting for repairs, maintenance, and improvements. Misunderstanding these items can wreak havoc with your tax planning.

If you spend money on repairs or on maintenance, that spending creates a deduction which gets included in your taxable income or loss calculations. If you're able to take losses because of the special allowance rule, the real estate professional rule, or just because you've got other real estate investments generating profits, repairs and maintenance spending generates immediate tax deductions. And those tax deductions generate immediate tax savings.

What are repairs? A repair returns an item to its previous condition. For example, if you have a pipe burst and need to replace sheetrock and carpets because of the water damage, that's a repair. If an appliance breaks and you call the service technician to replace a part, that's a repair.

What is maintenance? Maintenance maintains some item in working order. Painting the inside or outside of the property is maintenance. Replacing carpet every three years is maintenance. Regularly replanting foliage or reseeding lawns is maintenance.

Money you spend on an improvement, however, shouldn't be simply deducted. Rather, improvements need to be depreciated—usually over 27.5 years.

What is an improvement? Improvements either extend the life of the property or increase the utility of the property. Improvements include items such as roof replacement, new siding, and new gutters because these items all clearly extend the life of the property. Improvements also include items such as a new air conditioning system, an attic built-out, new landscaping, and an irrigation system because these items all clearly increase the utility of the property.

Discerning whether a particular item is repair, maintenance, or improvement is tricky. But you can probably roughly think about expenditures on repairs and maintenance as money you spend so you can continue to rent the property at current rent levels over the next year. You can think about expenditures on improvements as money you spend to increase your rents or to extend the life of your property.

Taxes on Sale of Property

One final topic should be discussed: how you get taxed when you sell the property. So let me just do that quickly.

You might think that if you originally bought a property for $100,000 and then sold the property for $200,000 that you'll only pay taxes on the $100,000 of profit. But the calculations are a little trickier than that, unfortunately.

You actually need to make three adjustments to the original purchase price. First of all, you'll need to subtract any depreciation you either deducted or that you were supposed to deduct from the purchase price value.

Second, if you have suspended passive losses, these get added back to the purchase price.

Third, finally, any selling costs also get added back to the purchase price.

For example, if you bought a property for $100,000, took $50,000 of depreciation over the years you held the property, were prevented from taking $25,000 of passive losses, and then spent $15,000 on selling costs, your actual real estate gain on sale gets calculated like this:

Original purchase price	$100,000
Subtract: depreciation	-$50,000
Addback: suspended passive losses	$5,000
Addback: selling costs	$15,000
Adjusted purchase price to use in profit calculation	$70,000

Selling price	$200,000
Gain (selling price – adjusted purchase price)	$130,000

Table 5: Calculation a real estate taxable gain

One other little wrinkle related to the real estate taxable gain: if a part of the real estate gain is really a reversal of the depreciation the investor has taken in the past, that chunk of the profit gets taxed at a higher tax return.

Specifically, “depreciation” profits are taxed either at 25% or at the taxpayer's marginal income tax rate when that marginal rate is lower than 25%.

I think I would not worry too much about getting precise about tax rate on the “depreciation” profits. (These “depreciation” profits are actually called “Unrecaptured section 1250 gain” and discussed in the Chapter 16 of IRS Publication 17, which is available at the www.irs.gov website.)

I don't actually make any effort in the Short Sale Analyzer workbook to calculate the extra “depreciation” profits tax you might pay in, say, ten years because a small chunk of the gain is taxed at a higher rate. The main things to know are that you may need to pay back some of the depreciation... and that things like suspended passive losses and selling costs factor into your gain calculations.