April 15 can be considered one of the most stressful days of the year. With thoughts of active and passive income, depreciation, tax deductions, passive activity losses and tax credits, it is enough to send anyone into a tizzy. For this reason, we will review ten things real estate investors should consider during tax season.
1. Am I considered a real estate professional?
Whether the IRS classifies you as a real estate professional or not can make a huge impact on the amount of losses you can claim and your overall tax liability. If you are classified as a real estate professional, you are not subject to the passive activity loss limits, and you may also deduct rental losses against ordinary income. That’s huge when thinking of ways to create tax savings.
For tax purposes, a person is considered a real estate professional if:
(a) More than 50% of the taxpayer’s personal services performed in all trades or businesses during the year are in real property trades or business in which the taxpayer materially participates.
(b) The taxpayer performed more than 750 hours of personal services in real property trades or business in which the taxpayer materially participates.
(c) The taxpayer meets the state’s licensing requirements if there are any (the licensing requirements vary by state).
2. If I materially participate in rental real estate activity, am I eligible for the $25,000 Special Allowance?
If you materially participated in rental real estate activities, you are eligible for the $25,000 Special Allowance for active participation in real estate activities. You materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis
The $25,000 special allowance allows taxpayers who are active participants (or spouse) in real estate activities to deduct up to $25,000 from non-passive income.
3. If I do not materially participate in real estate activities, what are my passive activity loss limitations?
If you do not materially participate in real estate activities, the IRS limits your passive activity losses to your earnings from passive activity. Losses in excess of gains from activity are carried forward to future years.
4. What if I mischaracterized my real estate activity and income?
If you derived net income from the following passive activities, you may have to recharacterize the income and excluded it from passive activity income:
- Significant participation passive activities
- Rental of property when less than 30% of the unadjusted basis of the property is subject to depreciation
- Equity-financed lending activities
- Rental of property incidental to development activities
- Rental of property to nonpassive activities
- Licensing of intangible property by pass-through entities
5. Am I subject to self-employment tax as a real estate professional?
Even though you may be self-employed as a real estate professional, the taxpayer generally reports rental income and expenses on Schedule E (Form 1040), Supplemental Income and Loss, because income from rental real estate is not a trade or business subject to Self-Employment tax (SE). SE tax is based on Schedule C (Form 1040), Profit or Loss from Business, net earnings.
In general, as a real estate professional, you will continue to use Schedule E, line 43, reconciliation for real estate professionals and complete Form 1040.
6. What if I provide additional services in addition to the real estate activity I conduct?
If you are a real estate professional and you provide substantial personal services in addition to renting real estate, you will report your activity to Schedule C of form 1040. This income is then subject to Self-Employment tax.
7. Am I qualified for the Qualified Business Deduction?
Although the income you generate from rental activity is generally passive income reported on Schedule E (Form 1040), if the rental activity rises to the level of a trade or business the rental income can be qualified business income (QBI).
8. I made a section 1031 exchange during the tax year -- now what?
If you made a section 1031 Tax Deferred Exchange during the year, you will need to report this exchange on IRS Form 8824. Form 8824 is used to report each exchange or investment real property of a like kind.
9. Can I take a deduction for fees I pay to the Homeowners' Association?
If you pay homeowner’s association fees on your rental property, you may have a deduction for the fees paid. The IRS allows deductions for expenses that are ordinary and necessary expenses for managing, conserving and maintaining your rental property.
10. Can a real estate investor file for an extension of time to file their taxes?
With tax season fast approaching, you may want to consider filing for an extension by filing IRS Form 4868. This will give you an automatic six months to file your tax return. By filing an extension, you will have more time to gather all your documents and more time to work with your tax advisor. This will limit the potential for any errors and limit the chances of any future IRS audit.
The Millionacres bottom line
With tax season vastly approaching, you will need to think about the real estate activities that you participated in throughout the year in order to be prepared for the tax filing season. The best time to start working on your taxes and gather documents is now. Get your tax documents organized and don’t go at it alone. Working with a tax professional will help you to optimize your tax savings and help you develop some tax strategies for future years.