Done right, real estate investments and rental property can provide tax savings. The associated bookkeeping also requires a comprehensive understanding.
"The only place success comes before work is in the dictionary."
Real estate often provides tax losses which can offset other taxable income. Losses may be generated through depreciation deductions. It is important to know the specific tax status an individual will be reporting for the real estate venture to accurately prepare a tax plan or tax return.
Accurate bookkeeping will also provide actionable reporting of gains, losses, income and deduction to help identify profit in the real estate venture.
A real estate professional is an individual or married couple who:
● invests at least 750 hours annually managing real estate investments
● does not hold a full-time job, although the spouse may be employed; this is what makes real estate investing attractive to high income earning professions, such as attorneys and doctors
● documents on a detailed time log the time investments into the real estate investment portfolio
● enjoys deductions and losses beyond the passive loss limitation
“Real estate professional” as a term is defined in the federal tax code. Failing to maintain a written and detailed time log is a leading cause of losing real estate professional status in a tax audit. We can provide a sample time log as well as tax planning to ensure deductions are maximized for tax savings. Detailed mileage logs must also match the time log.
The IRS permits multiple properties in a real estate venture to be grouped together to qualify for real estate professional status. It is important to note, however, that the ventures be grouped on a single tax return, such as your personal tax return or a business tax return.
Unfortunately, short-term rental properties (AirBnB or vacation properties) generally do not count toward real estate professional status.
Most individuals who invest in real estate do so through rental property, whether residential or commercial. Real estate is held for long-term investment purposes, such as income or capital growth. A real estate investor reports the sale of real estate as capital gain/loss and deductions depreciation during the time of ownership.
An individual holding real estate for resale may be a real estate dealer. The real estate properties are treated as inventory, and sales are reported as ordinary taxable income. A property acquired for flipping may be an example of a real estate dealer, as well as a developer who subdivides property and sells off individual lots. Once again, accurate bookkeeping is necessary to ensure all deductions are taken.
An individual can hold multiple real estate properties, some of which are treated as real estate investor status and others as real estate dealer status.
Real estate investments are often subject to passive loss limits, particularly if the investor does not qualify for real estate professional status. By default, real estate is considered by the IRS to be a passive activity, and passive losses generally only offset passive income. The exception is that up to $25,000 of the loss may be used to offset wages or other active income. This is known as the passive loss limit, which limits the amount by which losses on real estate ventures may be applied to a tax return in a single tax year.
It is important to note that the passive loss limit applies to all real estate properties owned in a venture, and not to each parcel of real estate.
By definition, a short-term rental property is classified as an active business and as such already enjoys the ability to deduct losses beyond the passive loss limit. Thus, some investors may focus primarily on short-term rental properties as opposed to long-term investment property. A short-term rental is usually defined as a rental of 7 days or less. However, short-term rental property may be subject to self-employment taxes because it is an active business venture.
Individuals who embark on flipping real estate are likely to be treated as a real estate dealer for tax purposes. This may be the most simple aspect of real estate flipping. By nature, real estate flipping demands a complex accounting system, particularly if there are multiple properties underway at the same time.
Separating the profit and loss statements by properties requires a robust and complex bookkeeping system which permits the client to view the profitability of each property and treat each property as a separate source of revenue. QuickBooks can be made to function well for property flippers, given attention to detail. Without this detail, your bookkeeping and accounting may not provide actionable information on the profitability of your venture.