Tax Strategies for Real Estate Professionals that are Also Property Investors

Are you a Southern California or San Diego real estate professional that also invests in real estate? I get a lot of clients contacting me about tax and accounting strategies related to property investments. If you’re a high-income taxpayer who wants to put big real-estate-related tax deductions onto a tax return then this blog post could be useful to you.  I recently came across an interesting article from Stephen Nelson CPA, of Evergreen Small Business, where he laid out a tax strategy for real estate investors, that really only works; 

1. if you are a full-time real estate agent, a broker, or a property manager who wants to also directly invest in real estate 
2. or individuals who own and operate real estate trades or businesses. So, like construction company owners.    

The reason is that these strategies and advantages only work if you can actually qualify as being “a real estate professional” more on this later. 

Real Estate Professional Tax Strategies 

Mr. Nelson points out that “real estate professional tax strategy works mostly because of the depreciation deduction an investor enjoys.” He uses an example scenario of say a person was to purchase a rental property for $1,000,000. Perhaps using a $100,000 down payment and a $900,000 mortgage. Say the tenants pay them $60,000 of annual rent. Suppose that amount covers the operating expenses and even pays the mortgage payment.   

Now if we look at this scenario from a purely economic point of view, the arrangement makes sense. The property may be appreciated. The steady mortgage payments may overtime pay off the loan. And the owner is probably making money.

The added bonus is that tax accounting rules allow the owner to add a large depreciation deduction to their return. In other words, even though their investment may slowly be growing in value, the person can write off a loss each year on the property. Maybe, in fact, around $30,000 annually for a property like the one just described?

Mr. Nelson points out that the problem is, most high-income investors don’t get to use that large depreciation-derived tax deduction. (Middle-class investors do by the way.)

Example 1: A couple who earns $200,000 from jobs and owns an investment property that generates a $30,000 loss due to depreciation. They would like to use the $30,000 loss to shelter some of their earned income. But they cannot. Tax laws limit their passive loss deductions.

Tax laws allow some taxpayers to use these passive losses, however. And one group who can? Real estate professionals.

Example 2: Another couple who also earn $200,000 from jobs and also own an investment property that generates a $30,000 loss. John and Abigail can use the $30,000 loss to shelter some of the income they earn in their jobs. And the reason? Because John qualifies as a real estate professional.

So How Do You Make the Real Estate Professional Tax Strategy Work

The way you take advantage of this tax strategy is to qualify as a real estate professional.

The tax law is written to examine two things for being able to qualify as to be able to qualify as a real estate professional for tax purposes:

1.  Does a taxpayer or one of the taxpayers on a married joint tax return work in  “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
2. Must spend more than fifty percent of their work time in the real estate trade or business. Spend more than 750 hours working in the real estate trade or business. Materially participate in the real estate investment generating the passive loss.

Tip: By the way? The keyword to pay attention to in the quoted language (which comes from the statute)? The word “any.”   

One final note about working in a real property trade or business. An individual qualifies as working in a real property trade or business if she or he owns a sole proprietorship or is a partner in a partnership that, for example, does development, construction, rental, management, or brokerage. And an individual qualifies as working in a real property trade or business if she or he works as an employee of a corporation and owns five percent or more of the business.

Example 3: The married couple that Mr. Nelson used in his previous example shows $200,000 of income from jobs on their tax return and a $30,000 real estate loss. They get to deduct the $30,000 loss because one of them qualifies as a real estate professional. One way that he might qualify? If he owns more than five percent of a corporation that operates a construction trade or business.

Potential Tax Savings from Using the Real Estate Professional Tax Strategy

When the strategy is set up correctly, a large depreciation deduction or a collection of deductions often shelters other highly taxed income a taxpayer earns. 

Example 4: A single, self-employed real estate broker earns $300,000 working full-time at his business. He also invests in real estate properties and materially participates in their operation. As result, any loss generated by the investments shelters his income. If an investment breaks even in terms of cash flows but generates a $100,000 loss due to depreciation, for example? He nets the $300,000 of broker earnings with the $100,000 of the rental losses. The result? He pays income taxes on $200,000 and so probably annually saves $30,000 to $40,000 in federal and state income taxes.

If a married couple files a joint tax return and combines a high-earner with a real estate professional, the tax return can use real estate losses to shelter the non-real estate professional’s income.

Example 5: A married couple includes a high-earning spouse who makes $1,000,000 in a W-2 job and a spouse who works half-time (so roughly 1,000 hours a year) managing the family’s rental property portfolio. The rental portfolio generates a small positive cash flow but on paper due to depreciation shows a $400,000 loss each year. The couple pays taxes on the $600,000 net income and probably saves about $150,000 in federal and state income taxes.

How to 10X the Real Estate Professional Strategy    

Typically real estate investors depreciate a commercial property over 39 years and residential property over 27.5 half years. 

If an investor buys a $1,000,000 property that represents $200,000 of land and $800,000 of building, the investor depreciates just the $800,000 of building.   

To calculate the annual depreciation for an $800,000 commercial building, the investor divides the $800,000 by 39 years. So nearly a $20,000 annual depreciation deduction.

To calculate the annual depreciation for an $800,000 residential property, the investor divides the $800,000 by 27.5 years. So roughly a $30,000 annual depreciation deduction.

Taxpayers interested in larger deductions, therefore, may wish to focus on residential properties. Further, tax laws do provide real estate investors with another depreciation strategy into the early years of ownership: cost segregation. Properly classifying your fixed assets and increasing property depreciation is key to sound real estate management—and through the tax deductions and deferrals they generate, they free up cash you can reinvest immediately.

A cost segregation study or analysis breaks down the building part of the property’s cost—so $800,000 in the preceding paragraph—into real property (depreciated typically over 27.5 or 39 years) and personal property (depreciated very quickly and maybe even mostly in the first year or two of ownership).

An $800,000 apartment building for example might be cost segregated into $600,000 of real property that the taxpayer depreciates over 27.5 years and $200,000 of personal property depreciated mostly over the first year or two of ownership. 

Are There Any Limits to this Strategy?   

Mr. Nelson’s article points out the fact that starting in 2021, tax laws limit the excess business losses a taxpayer deducts in any one year to the amount of trade or business income shown on the tax return plus another $262,000 in 2021 and $270,000 in 2022 if unmarried or $524,000 in 2021 and $540,000 in 2022 if married.

This limitation means that the highest-income taxpayers can’t always shelter all their W-2 income via the real estate professional tax strategy.

Example 6: A married couple includes an executive earning $2 million annually in W-2 wages and a spouse who manages the family’s real estate rentals. The property manager spouse qualifies as a real estate professional. And the rental portfolio loses (on paper) $1 million annually. For 2021, the couple however can only use $524,000 of real estate losses to shelter the W-2 income.

Situations When this Strategy Does not Work 

If you get audited for claiming these tax strategies and you cannot prove the investor activity hours, or when a taxpayer instead managing their own properties decided to hire an outside property manager. 

Example 7: say a taxpayer spends 1000 hours working in his real estate trade or business. That amounts to more than fifty percent of the time he works in a trade or business. Accordingly, he assumes he qualifies for the real estate professional tax strategy. Unfortunately, because he doesn’t get involved in the daily operations of the properties, he cannot count 150 hours of investor-type activity. Further, because he hired an outside property manager, he cannot count 150 hours of property-management-type activity. With only 700 hours counting toward the 750-hour minimum threshold, he fails to qualify for real estate professional status.

A second reason the real estate professional tax strategy fails? Because an investor fails to create a time log that an auditor accepts. This can be a bummer when it happens. The tax laws suggest a reasonable approach to the recordkeeping works and that estimates are okay. Auditors, however, often seem to want extremely high-quality contemporaneous time records as well as third-party proof.

Conclusion 

Circling back to the beginning of this article, I mentioned that these strategies work best for taxpayers who work as full-time real estate agents, brokers, and property managers and want to also directly invest in real estate. As well as individuals who own and operate real estate trades or businesses. So, like construction company owners.

Lastly, Mr. Nelson mentions that high-income married couples can often make the strategy work extremely well. If one spouse earns a large income (say $1,000,000) and the other spouse manages the couple’s rental portfolio and generates large paper losses due to depreciation deductions (say $500,000 a year), the spouses can dramatically reduce their income taxes by netting the W-2 wages with real estate losses. If you want to learn more about passive loss limitation rules and the material participation rules get covered in depth in the check out Treasury Regulations for Section 469.  Remember that it’s always best to speak with a professional CPA or tax advisor about your situation first.  If you have any questions or would like a free consultation don’t hesitate to contact us.