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The Real (Tax) Deal
Purchasing real estate as investment property can provide you with some substantial
tax savings. However, there are a few pitfalls to look out for in your process of
acquiring investment property.
Special Tax Rules for Rental Activities
Once you acquire the property, do you plan on charging rent on the real estate?
Some individuals can deduct up to $25,000 of rental real estate loss allowance in
one year. If the property produces a paper loss after depreciation has been taken
into account, the losses can offset other ordinary income on your tax return.
Depending on your effective tax rates, you could be looking at a potential tax
savings of up to $8,750 on your federal return alone. However, there are some
limitations on the losses as follows:
- If the taxpayer's modified AGI (Adjusted Gross Income) exceeds $100,000, the loss
allowance will begin to phase out.
- The allowance is reduced to zero when modified AGI reaches $150,000.
- The taxpayer must "actively participate" in the rental activity. Active
participation requires at least a 10% ownership in the rental property.
- Married-filing-separate taxpayers will have the allowance reduced to $12,500 with
AGI limitations beginning at $50,000 instead of $100,000.
Are You a Real Estate Professional?
* Next 37 17 investors only!
It is possible that the rental loss allowance will be waived under certain
circumstances, such as qualifying for the classification of a real estate
professional. To determine if you can be classified as a real estate professional
in the IRS's eyes, you must meet two requirements every year:
- More than 50% of your personal services during the tax year must be performed in
real property, trade or businesses,
AND
- You spend more than 750 hours of service during the tax year in real property
trade or businesses.
Once established as a real estate professional, you must meet one of several
criteria that define material participation in each rental activity. One example of
these criteria is if the taxpayer participates in the activity on a regular,
continuous and substantial basis during the year, and participates more than 100
hours.
The good news is that if the above requirements are met, the $25,000 rental loss
allowance limitation does not apply to you!
What Expenses Can Be Used to Offset Rental Income?
Here are some of the items that can be claimed as a deduction to offset the rent you
will receive on the property:
- Mortgage interest
- Real estate taxes
- Insurance
- Utilities
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- Maintenance
- Minor repairs
- Condominium fees
- Depreciation
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- Advertising
- Travel
- Professional fees
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All of the above examples would apply to the portion of the property that was
actually rented during the year.
Mixed-Use Property
Expenses can be limited on mixed-use property depending on the extent of personal
use by the taxpayer. A basic example of mixed-use property is a vacation home that
is used by the taxpayer personally and rented during the year as well.
The key to the limitation of expenses is as follows:
- If the property is rented for 14 days or less, no rental income is recognized
and no expenses are allowed.
- If personal use is no more than the greater of 14 days or 10% of the number of
days rented at fair value, then all expenses allocated to the rental portion are
allowed, and any expense in excess of income is subject to limitations.
- If personal use is more than the greater of 14 days or 10% of the number of days
rented at fair value, deductions are limited to gross rental income, and unused
deductions may be carried forward to future years.
In addition to the potential tax savings, another benefit of purchasing real estate
is that you've acquired an appreciating asset to diversify your investment
portfolio. As both a CPA and an Investment Advisor, I always like to see that
combination!
Sonia M. Stingo CPA, PFS is a partner at Livingston & Haynes, a CPA firm located in
Wellesley, Massachusetts. She has been in practice for over 16 years serving
clients in real estate and various other industries. She can be contacted at
sstingo@lh-cpa.com or 781-237-3339.
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