Tax law may seem like a roadblock when it comes to saving big on taxes using real estate, but fear not! There are numerous clever tricks you can employ to deduct real estate losses on your tax return. With a little planning and strategic investing, you'll be surprised at the results.
Quick Review of Why Real Estate Produces Big Deductions
Before we dive into the tricks, let's quickly review how real estate can generate substantial tax deductions. Let's say you own a $1,000,000 property that generates $50,000 in rent. After deducting the property expenses, including mortgage interest, which amount to $50,000, you might assume the investment breaks even for tax purposes. However, tax accounting rules allow you to depreciate the property over a certain number of years. This depreciation can result in significant deductions and potentially a loss on your tax return.
Now, let's explore the tricks that can help you maximize your real estate deductions.
Trick #1: Active Real Estate Participant
The first and easiest trick is the active participant exception. If your modified adjusted gross income is $100,000 or less, you can deduct real estate losses of up to $25,000 per year. To qualify for this deduction, you or your spouse must own at least ten percent of the property and actively participate in managing it by making decisions related to tenants, property managers, and expenditures.
Trick #2: The Section 280A(g) Exception
A weird trick works for property owners who own a business structured as a corporation or partnership. In some cases, the corporation or partnership can pay rent to the property owner for the use of their real property. If the rent is considered an ordinary and necessary expense, it is deducted on the corporation or partnership return, while the property owner doesn't need to report the rental payments as income.
Trick #3: Self-Rental
This trick allows you to deduct real estate losses if you buy property to rent to another trade or business you own. By grouping the rental property trade or business with your operating trade or business on your tax return, you can sidestep the passive loss limitation. For example, if you own a professional practice and personally buy the building used for the business, you can deduct the real estate losses on your personal return.
Trick #4: Real Estate Professional
If you meet the requirements of a real estate professional, you can deduct real estate losses if you materially participate in the rental operation. To qualify as a real estate professional, you need to spend more than 750 hours and more than 50% of your work day in a real estate trade or business that you own. This can include activities such as property management, property development, and brokerage. By qualifying as a real estate professional, you can shelter your taxable income with real estate losses.
Trick #5: Short-term Weekly-or-less Rentals
If your average rental interval is seven days or less, you are considered to be in a non-real-estate business according to tax law. This means you can deduct non-real-estate losses if you materially participate in the business. Short-term rentals can be a lucrative way to deduct real estate losses, but it's important to follow the rules and regulations carefully.
Trick #6: Short-term More-than-a-Week Rentals
Similar to trick #5, this trick applies if you rent a property for an average of thirty days or less but more than a week and provide significant personal services. By materially participating in the non-real-estate business that includes short-term rentals, you can deduct real estate losses.
Sidebar: The IRS Definition of "Significant"
When it comes to providing personal services, the IRS has specific criteria for what qualifies as "significant." Merely providing daily maid service, for example, is not enough to meet the threshold. The level of personal services needs to be substantial, as outlined in the IRS regulations.
Trick #7: Rental Incidental to Extraordinary Personal Services
In certain situations, where residential facilities or commercial properties are used as part of providing extraordinary personal services, the rental activity is considered non-real-estate activity. This means you can deduct non-real-estate losses if you materially participate in the activity. Examples of such situations include hospitals renting hospital rooms or colleges renting dormitories.
Trick #8: Rental Activity Incidental to Nonrental Activity
If a rental activity is only incidental to the main trade or business, the losses connected to the rental property are not limited by the passive loss limitation rules. Examples of incidental rental activity include renting property for appreciation, leasing property to employees, or using property in a trade or business where the gross rental income is minimal compared to the overall business income.
Trick #9: Nonexclusive Rental Activity
If the use of property is nonexclusive, it doesn't count as a real estate rental activity. This applies to situations where the property is used by multiple individuals or businesses, such as a golf course that is available to the public. By materially participating in the nonexclusive-use activity, you can deduct real estate losses.
Trick #10: Insubstantial Rental Activity
Taxpayers can group activities for tax purposes, and in some cases, an insubstantial rental activity can be grouped with another trade or business. By grouping these activities, you may be able to deduct real estate losses. The threshold for insubstantial-ness is typically defined as less than 20% of the activity's income.
Trick #11: Insubstantial Nonrental Activity
Similar to trick #10, if an insubstantial non-rental activity is grouped with a rental activity, you may deduct real estate losses equal to the income from the non-real-estate activity. This can be useful when a non-real-estate activity is closely related to a rental activity and both can be considered part of a larger trade or business.
Trick #12: Other Passive Income
If you have passive income, you can deduct the passive losses incurred on an investment property. Additionally, you may unlock previously suspended passive losses by intentionally creating large passive losses in the current year. This strategy allows you to offset passive gains with passive losses and maximize your deductions.
Trick #13: Disposition of the Activity Generating Passive Losses
When you dispose of an activity that has generated passive losses, you can deduct those losses on your tax return. This means that if you sell a rental property that has accumulated passive losses over the years, the sale can unlock those losses and reduce your taxable income.
In conclusion, while tax laws may limit your ability to save on taxes using real estate, numerous tricks and exceptions exist that can help you deduct real estate losses or use real estate to shelter your other taxable income. It is always wise to consult with a tax advisor to ensure you navigate these strategies correctly. If you need professional assistance, consider reaching out to our CPA firm, Nelson CPA.