Real Estate Investing: Tax Benefits & Opportunities

You’ve heard me share my own lukewarm feelings about investing in rental properties  (or at least make sure you are getting involved with clear eyes & with the proper expectations) here and here.

My takeaways in those 2 articles notwithstanding, there’s obviously a reason that so many people want to get involved in real estate investing and I’d say that the tax benefits associated with it are definitely high on the list…

So let’s walk through what those tax benefits look like one by one, and most importantly for all of you thinking about getting involved in real estate investing, how & when they actually work in practice.

But before I get into the tax benefits & their application…I have to offer a caveat to this whole concept of “tax benefits” in the first place.

So many different CPA’s that we work with (and many more that I respect & engage with on social media) use the phrase “never let the tax tail wag the dog.”

It means that taxes should be a consideration in your financial decision making but they should never be the primary motivation to do something. And this is coming from the Tax Professional!

In fact, I just heard a CPA that SPECIALIZES IN REAL ESTATE say the same thing about real estate investing specifically: buying real estate because of the alleged tax benefits rather than because you think the return on investment (as compared to other investments you can make) is a recipe for frustration. 

And because real estate investing involves actual work & time involved (at least if you want to capture the tax benefits) you better make sure that the investment (income & appreciation) outperforms an index fund that you can set up without any additional time/upkeep.

This might sound like I’m picking an argument with a strawman that doesn't exist...I promise you I am not.

I have had dozens of introductory calls with prospective clients where they will tell me that they want to “get into real estate” and I’ll start asking questions like “Where do you want to buy your first property?” “Do you want to do short term or long-term rentals?” “Will you hire a management company?” What does your cash-on-cash return need to be for you to be comfortable?” and they’ll just brush my questions aside and say, “I have no idea….I just want to lower my taxes.” Well, sure, but it doesn't exactly work like that and even if it did, if it's a poor cash-on-cash long term investment....how does that help  us??

So I’ll say it again: the tax tail should never wag the dog. That said, let’s dive into the tax benefits themselves:

1. Deductible Rental Losses.

Now, it’s true that you can deduct losses from rental properties each year….but, to be blunt, I think this particular tax benefit is both overstated and doesn’t always apply in the way that clients realize when they first start thinking about getting involved in rental properties.

Rental losses are considered a passive activity loss…which means they can only apply to passive activity gains that you have throughout the year: it does NOT get to offset ordinary income (UNLESS you qualify as a Real Estate Professional which we will discuss below.).

Put more simply, this means that buying a rental property will not actually lower/offset your W2 taxable income the way you might think!

I remember a CPA colleague of mine telling me about a client couple that came to him with $500,000 of taxable income (both from W2’s) and they had just bought a rental property, fixed it up, bought furniture etc. and were expecting my CPA friend to tell them how much they saved in taxes (thinking those real estate losses would offset a large chunk of their $500,000 salary.) My friend had the unfortunate duty of informing these clients that they actually couldn’t use any of those losses…because there were no gains to offset (yet) & those losses could only offset passive gains!

Now, to be clear, this couple can push these losses into future years when they do have rental income (or they can use them when they sell the property if they have gains) but they can’t actually use the losses against ordinary income.

For this rental loss to be eligible to offset ordinary income, one spouse would have had to qualify as a Real Estate Professional… basically an acknowledgment that they work full time in real estate. This designation allows your rental property to be treated as a business…which would then allow you to include income and losses on your Schedule C….thereby reducing any ordinary income that you have that year.

This is the dream scenario. This is why real estate investing can look so attractive….using real estate losses to offset ordinary income!

The problem is….It’s not that easy to qualify unless you are already in real estate (real estate broker, flipping homes full time etc.).

In order to become a real estate professional (we’ll discuss the long-term rental market first) you have to spend 750 hours working in your rental business throughout the year AND spent more time working in your real estate than any other profession/trade. These are the first two tests. Once you satisfy these two, you also have to satisfy the material participation rule (of which there are 7 tests…and I don’t think we need to get into…but suffice it to say that you have to self-manage your real estate properties to qualify).

Re-read those last two lines…This doesn’t apply to most people!

Most people looking to get into real estate rentals have a primary job (doctor, nurse, attorney, product manager etc.) and are looking to buy a rental property for additional income. In these cases, even if they were to satisfy the 750 hours, they still would not qualify as a Real Estate Professional because they’d have spent more hours throughout the year in their primary job than in dealing with the property. A lawyer working 2,500 hours per year is not going to be able to say that he spends more time on his rental properties….he, very clearly, does not work in real estate.

And without this designation, there is no special tax treatment of real estate losses….they can’t use real estate losses to offset ordinary income…instead it would work just like losses that you accrue in the stock market….they can only be used against passive (capital) gains!

If you own a short-term rental, all of this works a bit differently: you can replace the Real Estate Professional designation as long as your average stay by guest is under 7 days…but this doesn’t get you out of doge.

Even if your average stay-by-guest is only 5 days, you still have to “materially participate” in the management of the property (two of the most common tests here are either working 500 hours on your real estate properties combined or working at least 100 hours per property AND more than anybody else on those properties).

In the short-term rental space, it’s the “materially participate” piece remains that is the toughest barrier to the designation…If you have a rental property in another part of the country (most likely utilizing Air B and B or Verbo) and you’re hiring cleaners after each stay, other people are hired to move furniture/set up before stays etc. it’s just very difficult to maintain that you work at least 100 hours on the property throughout the year and that you’re involved more than anyone else.

And this Is why its kind of a catch 22. A lot of people that talk about getting into real estate realize that it’s a lot of work they don’t want to do and choose to hire a management company instead.. Well, that’s fine…. But you can’t do that AND have this special tax status (because you wouldn’t be working on the property MORE than anyone else). Most of the time, it’s one or the other!

Ok so a lot of rules there, but the long and short of it (pun intended) is that you only receive the tax deduction against ordinary income if you genuinely treat your real estate like a primary business rather than just a source of income. (By the way, one way around this is if your married and one spouse doesn’t work….They could spend their time on the property and your household would qualify for the Real Estate Professional Designation.)

2. Depreciation.

As a rental property owner, you are able to deduct the costs of buying and improving a property on your tax return over the “useful life” of the property….this is called rental property depreciation.

We’re obviously not going to cover everything here, but just as overview, when you own a long-term rental property, you are able to deduct the purchase price of the property (and any additional costs/work that you do) over 27.5 years of owning the property (the IRS came up with this figure as the average “useful life” of a long term rental property….it’s 39 years for a short term rental.)

 So, as a rough example, if you bought a $300,000 property as a long-term rental, you can deduct $10,900 per year ($300,000 divided by 27.5 years) on your tax return each year that the property is in service. Like we discussed above with regards to losses, this $10,900 would not go towards offsetting your W2/ordinary income. Instead, it would be entered onto your Schedule E as a passive loss and would therefore only be used against your passive income (for example, if you had rental income from any of your properties) in that same year.

One quick note I think it worth mentioning even in this introductory explanation, is that only the building itself can be depreciated…not the land that the building exists on! (Land is not considered a depreciating asset that loses value over time whereas a building structure does.) This means that where you’re thinking about buying a rental property will impact the deprecation that you can take. 

For example, if you buy a home in California for $1,000,000 maybe the building itself is only worth $400,000…so you’re offsetting that $400,000 over 27.5 years rather than the full $1mm. Whereas if you buy in an area with lower property taxes/expensive land, you’d benefit from a more complete depreciation value on the same $1mm investment (and maybe spread over 3 separate properties.)

(And no…we are not going to get into cost segregation, bonus depreciation…time and place!)

There are two more ways that real estate investing can provide tax upside that I want to touch on here….because both seem to be particularly “buzzy” right now even if they’re only useful/utilized in more limited circumstances.

3. 1031 Exchange

This is when you sell your property at a profit and you take that profit and immediately use it to buy another property (rather than taking the money.) When you do this, you do not pay capital gains tax on the sale of the first home like  you would if you took the cash and just added it to your bank account…This can be an effective strategy when you want to remain in the real estate business for the long term, don’t need the money, and are comfortable/eager to delay the tax liability down the road.

4. Opportunity Zones.

Opportunity zones are a creation of the Tax Cut and Jobs Act of 2017. The government created them to incentivize Americans to invest in lower-income, under-developed areas.

Investors can re-invest assets that have large capital gains into an Opportunity Zone Fund (within 180 days of selling the asset or security that generated the capital gain) in order to limit their capital gains tax. If you leave the investment in the fund for 10 years than you avoid paying taxes on the entire capital gain that you would have paid taxes on at the initial point of sale (though you would pay taxes on the gains that have occurred since that time.)

Honestly, both because they’re so new and because it locks up non-qualified money for a full 10 years in order to benefit from the tax upside…I don’t see this too often.

I’ll leave you with a final thought. Rather than trying to turn your rental property INTO a business (via the Real Estate Professional designation) what if you actually started a side-hustle? What if you utilized your skills & knowledge to derive additional 1099/self-employment income? If neither is truly “passive”, all else being equal, I would rather generate additional business through my own knowledge/skills, while working on my own timeline, with business expenses that I’m actually able to write off, and without being subject to the whims of the “housing market.”

Again, rental properties can be a wonderful investment and the tax upsides can make them even more attractive….but there is a lot to look at before making this decision.

Let us know how we can help!

Feel free to reach out or schedule time on my calendar here.