A few years ago, I started working with a new accountant. In the first year, she saved me several thousand dollars. When I asked her how she did it, she simply told me my other accountants forgot to check a box.
This box is a tax advantage reserved only for real estate professionals. But don’t worry: If you’ve missed it in past years (like I did), you might still be able to reap the rewards retroactively.
Before we dive into how this method works, let’s first cover some tax terminology.
‘Real Estate Professional’ Defined
To take advantage of this method, you must be a “real estate professional.” According to IRS Publication 925, you must satisfy both of these requirements to qualify:
1. You must spend more time in real estate activities than non-real estate activities.
2. You have to spend at least 750 hours per year in real estate activities.
The IRS doesn’t care about your real estate license. They’re concerned with how you spend your time. And, if you are filing your taxes jointly with a spouse, only one of you must meet these requirements to use the benefit.
Passive Versus Active Income
There are two types of income according to the IRS:
1. Active income is money that you physically work for. Generally, these are W-2 or 1099 wages.
2. Passive income is the money you earn without working. It’s the interest on your savings account, dividends on investments and rental income.
As a real estate professional, you can deduct all of your rental losses against your active income, IRS Publication 925 also explains.
Depreciation and Amortization
Depreciation is taking a tangible asset — in our case, buildings and improvements — and expensing it over its useful life. To put it simply, the IRS doesn’t allow you to buy a property for $100,000 and take $100,000 worth of expenses in the first year. You have to spread them out over the life of the property.
According to the IRS, land does not depreciate. It always holds its value because there is a finite amount of it.
There are two ways you can take your depreciation expense.
1. Straight-line depreciation: This means you expense a set amount every year over the life of the property.
2. Accelerated depreciation: This means you get to take some or all of the expense upfront, instead of spacing it out every year.
Finally, amortization includes intangible assets like loan closing costs. It’s the stuff that you have to pay for in order to make the transaction happen. You can only take these expenses as straight-line depreciation.
Let’s Put It Together
Now that you understand the terminology, let’s look at an example:
• You buy a residential home for $50,000.
• Ten percent of that purchase price is land. So $5,000 of the $50,000 is land, which you cannot depreciate.
• The building needs $5,000 in improvements: a new roof, new coat of paint, etc.
• The closing costs are $5,000, and you’re taking out a 15-year mortgage.
Other important factors to keep in mind include:
• Residential properties have an expected life of 27.5 years (39 years for commercial buildings), according to the IRS.
• Improvements are eligible to be depreciated for up to 15 years.
• Amortization costs are spread across the life of the mortgage (in this case, 15 years).
Therefore, we can do some quick math to figure out the amount you can expense for depreciation each year:
• True price of the home: $50,000 – $5,000 (cost of land) = $45,000
• Building depreciation expense: $45,000/27.5 years = $1,636
• Improvements depreciation expense: $5,000/15 years = $333
• Amortization expense: $5,000/15 years = $333
• Total depreciation and amortization expense: $1,636 + $333 + $333 = $2,302
Using straight-line depreciation, you can expense $2,302 off of that $50,000 property every year. But let’s take a look at accelerated depreciation using the same numbers.
When using accelerated depreciation, the only thing that changes is the improvements expense. Instead of spreading it out over 15 years, you get to take the entire expense upfront.
So that means, in the example above, your improvements depreciation expense is $5,000 instead of $333. That’s an extra $4,667 in expenses upfront, meaning your total is now $6,969. The annual expenses after that first year will be $333 lower, but you’re getting far more upfront.
The Reason It Works
As I explained earlier, real estate professionals can deduct all of their passive rental losses against non-passive income. The same goes for any additional losses, like if you had a rental property sit vacant for several months.
Looking at the example above, let’s assume you have $9,000 in rental income losses because the property sat vacant for a portion of the year. With a total income of $150,000, you can then subtract the $9,000 in losses plus the $2,302 in depreciation and amortization expenses. If you went the accelerated depreciation route, that $2,302 turns into $6,969.
That comes to a total of $138,698 or $134,031 in taxable income, depending on whether you go for straight or accelerated depreciation.
The non-real estate professional, on the other hand, is still at $150,000 in taxable income in both scenarios. With a tax rate of 22%, the real estate professional is saving $2,500 or $3,514, respectively, on their taxes compared to the non-real estate professional.
If you are not a real estate professional, excess losses are called “passive losses” and carried forward for you to offset rental income or capital gains on your property in future years.
So, how do you gain this tax advantage? Just check the “real estate professional” box on your tax forms, assuming you are in fact a real estate professional. This applies to each individual property, and it can work retroactively. So if you bought a property three years ago but were ineligible to check the box, you can check it this year and potentially get the savings you missed.