Tax Guide Rental Properties 2019
Tax_Guide_Rental_Properties_2019
User Manual:
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Page Count: 46
1 The Basics P 4
2 Establishing a Home Oce P 6
3 Entity Selection P 8
4 Travel Expenses P 10
5 Real Estate Tax Strategies P 16
6 Capital Improvements vs. Repairs & Maintenance Expenses P 19
7 Depreciation P 21
8 Passive Losses, Passive Activity Limits & The Real Estate
Professional Status P 24
9 Capital Gains Tax and Depreciation Recapture P 28
10 Key Tax Issues for Short-Term Rentals P 35
11 20% Pass-Through Deduction P 38
12 Casualty Losses P 40
Overview
3
T
he rst part of eective tax strategy and planning is understanding that when
you le your tax returns each year, you’re simply reporting the results (income,
losses, etc.) of your activities from the prior year. Once the year ends, while there are
a few things that can be done, most of your results are already set in stone and you
will pay tax based on those results.
That means you need to be taking a proactive approach to tax strategy and planning
by implementing strategies and taking the right actions throughout the year so you’ll
end up with favorable results come tax ling season.
This guide is designed to give rental property owners tax strategies you can implement
now to minimize next year’s tax bill. You’ll also come away with a more precise and
nuanced understanding of your 2018 tax ling.
Introduction
This guide gives rental
property owners tax
strategies to minimize
next year’s bill and tips
for preparing and
understanding 2018
tax lings.
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2018 REAL ESTATE TAX STRATEGY GUIDE
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Before we get too granular, let’s cover some of the basic real estate tax
strategies that have served rental property owners well for decades.
RECORDKEEPING
While it isn’t necessarily a tax strategy, the importance of keeping organized,
detailed, and up to date records cannot be understated. Doing so will allow you
to see how much income your rentals are bringing in at any given time, and also
allows you to project future income and expenses. This is key in determining the
amount of estimated tax payments you’ll need to make, your tax bracket and
the tax strategies that make the most sense for you. Luckily you have this guide
and Stessa to help keep your accounting records up to date.
HELOC INTEREST
The Tax Cuts & Jobs Act no longer
allows you to deduct interest from
a home equity line of credit (HELOC)
unless it was used to acquire a
residence or substantially improve
a residence.
However, if you use a HELOC to
fund your rental business, the interest
will be tax deductible if you elect
to “treat the debt secured by your
residence as not secured by your
residence.” It sounds confusing but
of course makes perfect sense to
the IRS, because the interest tracing
rules allow you to deduct interest if
used for business purposes.
The Basics
TAX CUTS
& JOBS ACT CHANGE
2018 REAL ESTATE TAX STRATEGY GUIDE
Advertising/Marketing
Leasing Commissions
Professional Fees (Legal, Accounting, etc.)
Interest (Mortgage & Other)
Taxes (Property & Other)
Depreciation
Business Mileage
Education & Training
Bank Fees
Employees and Independent Contractors
Repairs and Maintenance
Insurance
Property Management Fees
Supplies
Utilities (Oil, Gas, Electric, Water, Phone, etc.)
Home Oce Expenses
Travel Expenses
Snow Removal, Landscaping, Pest Control, etc.
HOA Fees
Business Meals (50% deductible)
COMMON TAX DEDUCTIBLE EXPENSES
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Below is a table of the most common tax deductible expenses you’ll want to track throughout the year.
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As a rental property owner you can
dedicate a room, or a portion of a
room, to a home oce to secure a
home oce deduction.
Having a home oce also allows you to
deduct local transportation expenses.
Without a home oce, a trip from
your home to the business site will
be considered a personal expense.
With the home office, the same trip
will be considered a business expense.
REQUIREMENTS
AND BEST PRACTICES
Note that if you work o site, which is
often the case for real estate investors,
you can still deduct the home oce if
it is the location you handle your
administrative work (i.e. bookkeeping).
IRS Rev. Proc. 2013-13 allows for a “safe
harbor” deduction for anyone with an
established home oce. The deduction
is $5 per sqft of the home oce annually.
Alternatively, you can use the actual
expense method which allows you to
deduct a portion of your actual home
expenses. Divide the square footage of
your home oce by the total square
footage of your home to get the ratio.
Establishing a Home Oce
Per IRC § 280A, a home oce
must be used:
(1) regularly and exclusively as
the principal place of business;
and
(2) regularly and exclusively as
a place to meet or deal with
patients, clients, or customers
in the normal course or trade
of business.
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Then multiply the ratio by the total
amount of expenses that relate to your
entire home, to arrive at the deductible
amount for your home oce.
Note that any expenses related solely
to your home oce (e.g. an oce chair)
will be 100% deductible if you use the
actual expense method.
In order to substantiate a home oce,
you’ll want to put together a small
folder including the following:
• A statement as to what you use your
home oce for
• A oor plan showing where the
home oce is located in
your home
• Pictures of your home oce
EXAMPLE: HOME OFFICE DEDUCTION
100 sq ft / 1000 sq ft
HOME OFFICE HOME DEDUCTION
If your home oce is 100 square feet and your entire home is 1,000 square feet then
you can deduct 10% (100/1,000) of the expenses that relate to your entire home.
Utilities (Oil, Gas, Electric, Water, Phone, etc.)
Homeowner’s Insurance
Landscaping
Oce Furniture
Mortgage Interest (Not Principal)
Internet
Oce Supplies
If you plan to use the actual expense method you’ll want to track all the
expenses that relate to your entire home including but not limited to:
= 10% deduction on all home expenses
8
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As a rental property owner, you’ll most likely use a business entity to hold your
investments. This is done largely for asset protection purposes rather than tax
purposes as most are considered “pass-through” entities that don’t pay tax at the
entity level. Instead, the income/losses ow through to your personal tax return
(Form 1040) and are taxed based on your personal circumstances.
Before we jump into the most common entities that real estate investors use,
it is important to note that you should almost never put rental real estate in an
S or C Corporation.
These are corporate entities that are taxed at the entity level and often incur
negative tax consequences when assets are transferred out of the entity for estate
planning or other reasons.
SINGLE MEMBER LLC (SMLLC)
An SMLLC is the most common type of entity for individual real estate investors.
Entity Selection
You should almost never put
rental real estate in an S or C
Corporation.
9
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SMLLCs are separate from the owner for legal purposes, but disregarded for tax purposes.
This means that the rental activity in the SMLLC is reported directly on your Schedule
E as if you owned the property directly under your name.
When using an SMLLC it is important to treat it like a real business and have business
bank accounts, credit cards, etc. that are separate from your personal accounts.
MULTI MEMBER LLC (MMLLC)
Investors often use an MMLLC when multiple individuals invest in rental real estate
together. MMLLCs are generally taxed as partnerships and you’ll receive your portion
of the reported income or losses on a Schedule K-1.
The K-1 amounts are then reported on your personal tax returns (Form 1040) and
you’ll pay tax based on your personal circumstances.
When using an MMLLC it is important to treat it like a real business and have business
bank accounts, credit cards, etc. that are separate from your personal accounts.
Also, prior to starting the MMLLC, you’ll want to discuss prot/loss splits, capital
contributions, and how to handle unreimbursed partnership expenses with your
partners. Be sure to document this carefully in the operating agreement.
The K-1 amounts are
then reported on your
personal tax returns
(Form 1040) and you’ll
pay tax based on your
personal circumstances.
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In general, business travel must be considered both “ordinary and necessary” to be
tax-deductible. Ordinary means it is common and accepted within the trade or
business. Necessary means it is helpful and appropriate for the trade or business.
As a real estate investor, you’ll likely travel to and from your rental properties, other
business locations, new markets, and education related events. While most of these
activities are ordinary and necessary, it is important to understand the various
rules for deducting travel expenses.
LOCAL TRAVEL
Most rental property owners routinely travel to and from rental properties located
within driving distance. You might also travel to the bank, the hardware store, or to
meet with your broker, your attorney, and so on.
If you established a home oce, these miles are considered business miles and are
tax deductible within your “tax home.”
Travel Expenses
If you established a
home oce, rental
property-related driving
is considered business
mileage and is tax
deductible within
your “tax
home.”
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Your “tax home” is considered the geographic location (i.e. city or locality) where you
have an established rental business.
There are generally two ways you can deduct these trips:
1) Using the actual expense method, or
2) The standard mileage deduction.
Both methods require you to keep an IRS-compliant mileage log.
Remembering to log the trip each time you drive somewhere for business can be a
challenge. Use an automatic mileage tracking app like MileIQ in tandem with Stessa’s
mileage expense feature to make sure you’re not missing any deductible miles.
STANDARD MILEAGE RATE
The standard mileage rate is the simplest way to deduct local travel expenses
because it requires the least amount of tracking. Simply take the amount of miles you
drove for business and multiply it by the standard mileage rate to get your deduction.
The standard deduction for 2018 is 54.5 cents per mile for 2018 and 58 cents
per mile for 2019.
The only actual expenses you can deduct under this method, in addition to the
mileage, are parking fees, tolls, interest on a car loan, and personal property tax
on the vehicle.
An IRS-compliant mileage log includes:
• Odometer reading as of Jan 1
• Odometer reading as of Dec 31
For each business trip:
• The date
• The purpose
• The amount of miles
• Locations
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In order to use the standard mileage rate, you must use it in the rst year you use
your vehicle for business purposes, otherwise you can only use the actual expense
method. However, you can later switch to the actual expense method, and back
again, so it’s generally best to start with the standard mileage rate.
ACTUAL EXPENSE METHOD
Under the actual expense method, you can deduct a portion of your actual expenses
from operating your vehicle. These expenses include, but are not limited to:
Lease Payments
Interest on Car Loans
Gas and Oil
Repairs and Maintenance
Insurance
Car Washing
Tolls and Parking Fees
Other Fees (e.g. Registration Fees)
Depreciation
EXAMPLE: ACTUAL
EXPENSE METHOD
You drive a total of 10,000 miles in
2018. 6,700 are business miles.
Your business percentage for the
vehicle is 67% (6,700/10,000).
After tallying up all the expenses
related to your vehicle, the total is
$8,000 for the year. You can deduct
$5,360 for 2018 ($8,000 x 67%).
BUSINESS MILES TOTAL MILES
VEHICLE EXPENSE
6700 / 10,000
( )
X
$8,000
=
$5,360
ACTUAL EXPENSE DEDUCTION NOTE
Tickets and violations are NOT tax deductible.
13
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Your deduction is based on the percentage of actual miles driven that you used your
vehicle for business. This percentage is determined by dividing the amount of miles
you drove for business by the total miles you drove for the year (business miles/total
business and personal miles). You will also need to keep records (e.g. receipts) of all
other auto expenses throughout the year.
Stessa’s mobile app can help with this as it includes OCR and machine learning to
capture and automatically categorize receipts for free.
TRAVEL TO NEW MARKETS
Travel expenses are treated a bit dierently when traveling to a new market outside
of your tax home.
Travel expenses incurred to research and evaluate any new property that you eventually
purchase outside of your tax home, will be added to the basis of the property
and depreciated over 27.5 years. Once you purchase a rental property in the new
geographic area, additional new travel to the same area to evaluate other potential
acquisitions becomes tax deductible as a business expense.
Perhaps surprisingly, travel expenses incurred to evaluate property in a new market
in which you don’t eventually purchase a property are not immediately deductible.
These are considered start-up expenses that can only be deducted after purchasing
your rst property in the new geographic area.
Stessa’s mobile app can help keep
records of receipts and expenses
throughout the year.
14
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TRANSPORTATION
Transportation to and from the business destination is tax
deductible.
This includes but is not limited to airfare, train and bus tickets,
car expenses (see page 11).
Other transportation costs that are deductible include:
• Expenses for travel to and from the airport
(i.e. taxi, bus, etc.)
• From the lodging area (i.e. hotel, Airbnb, etc.)
to the business location (i.e. potential rental
property, conference center, etc.)
• Rental cars
Entertainment is no longer tax deductible under
The Tax Cuts and Jobs Act.
LODGING
Lodging expenses (i.e. hotel, Airbnb, etc.) on overnight
stays that are required for sleep or rest are deductible.
• Other Expenses
• Meals outside of your tax home are 50% tax deductible
• Dry cleaning
• Phone
• Tips
• Other ordinary and necessary business travel expenses
What Types of Travel Expenses are Deductible?
• fix mobile landing page / guide only ipad image, above fold
TAX CUTS
& JOBS ACT CHANGE
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MIXING PERSONAL & BUSINESS TRAVEL
When you mix business travel with personal travel, some of the expenses (i.e. airfare)
may still be tax deductible if the trip was primarily for business purposes.
In general this means you should be spending more than half of the total number
of days you’re traveling on business activities versus personal activities. A day is
considered a business day if you spend four or more hours on business activities.
It’s important to note, however, that lodging expenses, meals, and other expenses
incurred during days primarily dedicated to non-business purposes, are not tax
deductible. In addition, any travel expenses for a spouse (or child) that isn’t traveling
for a “bona de” business purpose is not tax deductible.
Also keep in mind that if the trip is primarily for personal
purposes, travel to and from the destination (i.e.
airfare) are not tax deductible but business expenses
incurred during the same trip are deductible.
EXAMPLE: BUSINESS
& PERSONAL TRAVEL
You go on a seven day business trip
to visit your out-of-state investment
portfolio and spend ve days on
business and the other two at
the beach.
Because the trip was primarly for
business purposes, the entire round-trip
airfare, plus lodging, meals and
related expenses for the ve business
days are tax deductible. However, the
lodging, meals, and other expenses
from the two personal days are
not deductible.
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Now that we covered the basics, let’s dive into some nitty gritty real estate tax strategies
that will ensure you’re paying as little tax on your rental income as possible.
THE IMPORTANCE OF DATE PLACED IN SERVICE
When you rst purchase a rental property it will be considered “placed in service”
on day one if there’s an existing tenant in the property. If there’s no existing tenant,
then the property is assumed to be not yet in service.
To place a property into service, you must meet two requirements: (1) the
property must be ready for use; and (2) the property must be available for use.
Generally, your rental is ready for use when the city or locality of your rental property
will conservatively issue a Certicate of Occupancy. The rental property is considered
available for use once it’s advertised for rent.
Rental property investors will often purchase a property vacant and in need of signicant
renovations before it’s ready to rent. Any renovation costs incurred before you place
Real Estate Tax Strategies
This section looks at real
estate tax strategies that
will ensure you’re paying
as little tax on your rental
income as possible.
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the property in service must be capitalized
and depreciated, generally over 27.5
years, regardless of whether or not
they are actual capital improvements or
simply repair and maintenance expenses.
The key point here is that costs that are
capitalized and then depreciated are
recovered over several years and then
are subject to depreciation recapture
(a 25% tax when you sell the property).
Regular repair and maintenance
expenses are fully deductible in the
year incurred and are not subject to
depreciation recapture.
The way to successfully manage this
distinction from a tax perspective is to
complete the minimum amount of work
necessary to get the property ready for
lease, then immediately advertise it
for rent.
As mentioned above, the denition of
ready for lease will be determined by
the building codes in your locality, but
is typically when sheetrock is on the
walls and the ooring is nished. In
other words, if the property is habitable
and no longer dangerous, it’s probably
also ready for lease.
Once the property is in service you
can nish the renovation and deduct
some of the costs as repair and main-
tenance expenses in the current year.
Other start up costs such as appliances,
which are normally considered capital
improvements, become deductible in
the current year under the de minimis
safe harbor provision of the tax code.
Note that some renovation costs will
always be considered capital improve-
ments regardless of whether or not a
property has already been placed in
service (e.g. replacing the entire roof).
PRO TIP As a best practice,
you’ll want to get in the habit of
itemizing your invoices so that
you, or your accountant, can
more easily categorize these
items as repair and maintenance
expenses or capital improvements.
Itemized invoices are also helpful
in determining whether expenses
might qualify under
one of the safe harbors
mentioned in the next
section or for 100% bonus
depreciation.
RECEIPT
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Before you place the property in service:
• Fixing structural issues (e.g. cracks in
the foundation)
• Replacing an entire roof, oor, bathroom,
kitchen, or plumbing system
• Adding a deck or new HVAC system
After you place the property in service:
• Painting
• Installing appliances
• Replacing a doorknob or window
• Repairing an existing plumbing system
• Other minor repairs
EXAMPLES OF RENOVATION ITEMS & WHEN TO COMPLETE:
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Once your property is in service, you’ll need to determine whether each repair and
maintenance expense you incur should be classied as a regular expense or a
capital improvement that must be capitalized and depreciated.
Most rental property owners will prefer to have as many of these costs as possible
classied as regular repair and maintenance expenses in order to maximize current
year deductions and minimize depreciation recapture.
Next, we’ll examine the dierences between these two classications and explore
some common examples of each. But before we do, we want to make you aware of
three safe harbors that may prove useful in moving some expenses that would otherwise
be classied as capital, into the regular expenses bucket:
• Safe Harbor for Small Taxpayers
• Routine Maintenance Safe Harbor
• De Minimis Safe Harbor
Capital Improvements vs. Repairs
& Maintenance Expenses
For most rental property
owners, classifying repair
and maintenance expenses
as regular repairs will
maximize current year
deductions and minimze
depreciation recapture.
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We won’t go into all the details of these
three safe harbors here, but the IRS
ocial guidance on these safe harbors
is required reading for rental property
owners that want to maximize their
current year deductions. You’ll also
learn quite a bit about how the IRS
approaches capital improvements versus
repairs & maintenance expenses.
REPAIRS AND MAINTENANCE
Repairs and maintenance are
generally one time expenses that are
incurred to keep your property habitable
and in proper working condition.
Include but are not limited to:
Painting
Fixing:
• an existing AC unit
• a faucet or toilet
Replacing:
• a few shingles on a roof
• a cabinet door
• a few planks or tiles on a oor
• a broken pipe
Costs incurred to:
• inspect, or clean part of the
building structure and/or build-
ing system
• replace broken or worn out parts
with comparable parts
CAPITAL IMPROVEMENTS
A capital improvement is an addition or
change that increases a property’s value,
increases its useful life, or adapts it (or
a component of the property) to new
uses. These items fall under categories
sometimes called betterments, restorations,
and adaptations.
EXAMPLES: COMMON
REPAIR & MAINTENANCE
EXPENSES
• Additions (e.g. additional room, deck,
pool, etc.)
• Renovating an entire room (e.g. kitchen)
• Installing central air conditioning, new
plumbing system, etc.
• Replacing 30% or more of a building
component (i.e. roof, windows, oors,
electrical system, HVAC, etc.)
EXAMPLES: CAPITAL
IMPROEMENTS
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Depreciation is one of the biggest and most important deductions for rental real
estate investors because it reduces taxable income but not cash ow.
For many landlords, the most important part here will be determining a property’s
depreciable basis. The goal is to allocate as much of the property’s purchase price to
the building value as possible to maximize your depreciation expense since land is
never depreciated. The portion allocated to the building will be depreciated over
27.5 years, per the IRS guidelines for residential income property.
While allocating 20% to land and 80% to the building is a common practice, under an
audit you may have to substantiate why you chose these numbers. This is commonly
done by nding the land versus building value on an appraisal or property tax card
led with the county. You can also use comparable land sales to make this determination
or commission a cost segregation study or appraisal by a third-party professional.
Should you decide to deviate from the county tax assessor’s land versus building
value ratio, you’ll need to be prepared to support your determination in an audit
with independent documentation prepared by a third-party professional.
Depreciation
Depreciation is one of
the most important
deductions because it
reduces taxable income
but not cash ow.
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COST SEGREGATION STUDIES
& 100% BONUS DEPRECIATION
In a cost segregation study, certain costs previously classied as 27.5 year property,
are instead classied as personal property or land improvements, with a shorter 5,
7, or 15-year rate of depreciation that uses accelerated methods to increase your
near-term deductions. It sounds complicated but most tax accountants and some
software will do the math for you.
Generally between 20-30% of the property’s purchase price can be reclassied under
these shorter class lives which can signicantly increase a property’s depreciation
expense. Thanks to The Tax Cuts and Jobs Act, 5, 7, and 15-year property is now eligible
for 100% bonus depreciation, which means its entire cost can be written o in the
rst year of ownership.
5, 7, and 15-year property is now
eligible for 100% bonus depreciation,
which means its entire cost can
be written o in the rst year
of ownership.
TAX CUTS
& JOBS ACT CHANGE
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It’s important to note that cost segregation
studies make the most sense for
landlords who are considered real
estate professionals for tax purposes
or expect to come in under the passive
loss limits discussed below.
Cost segregation studies may also be
worth considering if you consistently
have net income from passive activities
or a capital gain from the sale of a
rental, since losses generated by rental
properties can generally oset other
passive income or gain from the sale of
rental property.
EXAMPLE: COST SEGREGATION
A building with a value of $100,000 will typically have $3,636 in annual depreciation
($100,000/27.5). However, if you were to commission a cost segregation study and
nd that 20% of the building’s value can be reclassied as personal property or
land improvements, you could then deduct $20,000 in 100% bonus depreciation,
and enjoy another $2,909 in regular annual depreciation for a total depreciation
deduction of $22,909 in the rst year.
ANNUAL
DEPRECIATION
100% BONUS
DEPRECIATION
TOTAL DEPRECIATION
DEDUCTION
$20,000 + $2,909 =$22,909
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As a rental property owner, it’s not uncommon for your properties to produce a net
loss for tax purposes thanks to depreciation and other operating expenses.
The treatment of these losses is often misunderstood by investors for various
reasons, so we’ll spend some time here to clear up common misconceptions.
Losses from rental property are considered passive losses and can generally only
oset passive income (i.e. income from other rental properties or another business
in which you do not materially participate, not including investments). If these
passive losses exceed your passive income, they are suspended and carried forward
indenitely until future years, when you either have passive income or
sell a property at a gain.
This is good news because a net loss (for tax purposes) means you aren’t paying
taxes on your rental income today, even if you have positive cash ow.
Generally, the only time passive losses will oset your ordinary income from a W-2 job
or another trade or business is under one of the circumstances discussed below.
Passive Losses, Passive Activity
Limits & The Real Estate Professional Status
Losses from rental property
are considered passive losses
and can generally only oset
passive income.
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PASSIVE ACTIVITY LIMITS
Under the passive activity limits you can
deduct up to $25,000 in passive losses
against your ordinary income (e.g. W-2
wages) if your modied adjusted gross
income (MAGI) is $100,000 or less. This
deduction phases out $1 for every $2
of MAGI above $100,000 until $150,000
when it is completely phased out. Note:
these limits apply to both those ling
single or married ling joint.
In addition, in order to take losses against
you ordinary income, you must materially
participate in the activity by meeting one
of the following seven tests:
1. You participated in the activity for
more than 500 hours.
2. Your participation was substantially
all the participation in the activity
of all individuals for the tax year,
including the participation of indi-
viduals who didn’t own any interest
in the activity.
3. You participated in the activity for
more than 100 hours during the tax
year, and you participated at least
as much as any other individual
(including individuals who didn’t
own any interest in the activity) for
the year.
4. The activity is a signicant participation
activity, and you participated in all
signicant participation activities for
more than 500 hours. A signicant
participation activity is any trade or
business activity in which you
participated for more than 100
hours during the year and in which
you didn’t materially participate
under any of the material participation
tests, other than this test.
5. You materially participated in the
activity (other than by meeting this
fth test) for any 5 (whether or not
consecutive) of the 10 immediately
preceding tax years.
6. The activity is a personal service
activity in which you materially
participated for any 3 (whether or not
consecutive) preceding tax years. An
activity is a personal service
activity if it involves the performance
of personal services in the elds of
health (including veterinary ser-
vices), law, engineering, architecture,
accounting, actuarial science, per-
forming arts, consulting, or any other
trade or business in which capital isn’t
a material income-producing factor.
2018 REAL ESTATE TAX STRATEGY GUIDE
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7. Based on all the facts and circumstances, you participated in the activity on a
regular, continuous, and substantial basis during the year.
Note: these are the same tests used to establish material participation as a real
estate professional discussed below.
Your MAGI is $100,000 for the year and your rental properties produce a net loss
of $30,000. As long as you materially participate in your rental activities you’ll be
able to deduct $25,000 of this loss against your ordinary income. The remaining
$5,000 will be carried forward.
Lets say, however, your MAGI was $125,000. In this case you can only deduct
$12,500 of the loss because each dollar over $100,000 reduced the amount you
could deduct by $0.50. If you’re MAGI was over $150,000 then you can’t deduct
any of these losses against your ordinary income and the entire $30,000 is
carried forward.
EXAMPLE: MAGI & PASSIVE ACTIVITY LIMITS
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THE REAL ESTATE
PROFESSIONAL STATUS
The real estate professional status
historically allowed real estate investors
to take unlimited rental losses against
their ordinary income. This has now
been limited to $250,000 in losses if single
(and $500,000 if married) under the
excess business loss limits introduced
by the Tax Cuts & Jobs Act.
In order to qualify as a real estate
professional you must spend at least
750 hours in a real estate trade or
business and more than half your
total working hours must be in a real
estate trade or business.
Due to these requirements, many
investors who work a full-time job or
full-time in another business that is not
real estate-related will have a hard time
qualifying as a real estate professional.
That said, simply meeting the above
requirements will not necessarily allow
you to deduct your rental losses against
your ordinary income. You must also
materially participate in the rental
activity using the same tests mentioned
above, but is most commonly done by
electing to aggregate all your rental
properties as one activity and then
working 500 or more hours in this
single activity per year.
Note that if one spouse qualies for the
750 hour test, both spouse’s time on the
rental properties count towards material
participation, and losses can then be
taken against either spouse’s income.
This is a great strategy for couples where
one spouse works in a real estate trade
or business, works only part-time, or not
at all outside of your investment activities.
Note: In any year you elect to be treat-
ed as a real estate professional for tax
purposes, you’ll need to keep a log of
all hours worked within a real estate
trade or business.
TAX CUTS
& JOBS ACT CHANGE
The real estate professional
status has now been limited
to $250,000 in losses if single
(and $500,000 if married)
under the excess business
loss limits by the Tax Cuts
& Jobs Act.
2018 REAL ESTATE TAX STRATEGY GUIDE
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For many real estate investors, the
biggest tax bills will arrive upon the sale
of your property. This is especially true
when all goes according to plan and
you’re selling into a strong market while
cap rates are low. Below we discuss
what taxes you can expect to pay after
the successful sale of a property and
how best to mitigate them.
CAPITAL GAINS TAX
If you hold your property for less than
a year before selling you’ll have to pay
tax at your ordinary income rates (up to
37%) on the gain. However, if you hold
Capital Gains
Tax and Depreciation Recapture
the property for over a year your gain
will taxed at the long-term capital gains
rate of 15%, or 20% if your income
exceeds $425,801 if single or $479,001
if married.
DEPRECIATION RECAPTURE
The dark side of depreciation is
depreciation recapture, which rears its
claws upon sale of a depreciated asset.
Depreciation recapture is the portion
of your gain attributable to the depreciation
you took on your property during prior
years of ownership, also known as
accumulated depreciation.
• If you hold property for
less than a year before
selling, gains are taxed
at ordinary income
rates up to 37%
• If you hold property for
over a year, gains are
taxed at the long-term
capital gains rate of
15-20%
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Depreciation recapture is taxed as
ordinary income up to a maximum
rate of 25%.
NET INVESTMENT INCOME TAX
(NIIT)
You’ll also face the Net Investment
Income Tax (NIIT) of 3.8% if your income
exceeds $200,000 if single or $250,000
if married. It’s important to note that
while the NIIT applies to both rental
income and capital gains, those that
closely follow this guide may not report
any taxable rental income. Finally, if you
meet the requirements to be considered
a real estate professional for tax
purposes, your real estate income is
not subject to NIIT.
You purchase a rental property in 2010 for $275,000 and later sell it in 2018 for
$450,000. Each year your depreciation expense was $10,000 ($275,000 / 27.5) for a
total of $80,000 in depreciation over 8 years. This lowered your adjusted basis in the
property to $195,000 making your total gain on sale $255,000 ($450,000 - $195,000).
The $80,000 of gain from depreciation is taxed at 25% for a total of $20,000. The
remaining gain of $175,000 is taxed at the long-term capital gains rate of 15% for a
total of $26,250. Also, because your total income was above $200,000, the entire gain
of $255,000 is subject to the 3.8 NIIT for a total of $9,690. When you add this all up
your total tax upon sale is $55,940 or nearly 22% of the total gain. You may also be
liable for state taxes, depending on your geography.
EXAMPLE: CAPITAL GAINS TAX AND DEPRECIATION RECAPTURE
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MITIGATING TAXES UPON SALE
As you can see from the example above, the tax upon sale can be substantial. Luckily
there are some things you can do to defer and/or reduce this tax liability.
TAX LOSS HARVESTING
In general, capital gains can be oset by capital losses. Tax loss harvesting is simply
the selling of capital assets (e.g. stocks or other real estate) at a loss to oset your
capital gain.
This most likely makes sense if you invested in stock, rental property, or another
capital asset with a fair market value that has now fallen below its adjusted basis
(purchase price) and is unlikely to recover.
1031 EXCHANGES
1031 Exchanges allow you to defer both the capital gains tax and depreciation re-
capture from the sale of a property and invest the proceeds into another “like-kind”
property, often called “trading up”. While you ultimately have to pay tax at some
point down the line, with the notable exception of inheritance, this allows you to
use the entire proceeds to purchase a new property, thereby increasing the size of
your portfolio at a faster pace that would otherwise be possible if you were paying
capital gains taxes upon each sale.
It’s important to note that 1031
exchanges have a very strict timeline
that needs to be followed and generally
require the assistance of a qualied
intermediary (QI).
1031 Exchanges allow you to
defer both the capital gains
tax and depreciation recapture
from the sale of a property and
invest the proceeds into another
“like-kind” property, often called
“trading up”.
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OPPORTUNITY FUNDS
Introduced by the Tax Cuts and Jobs Act, Opportunity Funds allow you defer and
reduce the capital gains tax from the sale of any capital asset. Unlike a 1031 exchange,
you only have to redeploy the capital gain, not the entire sales proceeds.
If you invest the capital gains in an Opportunity Fund within 180 days and hold it
for 5 years you’ll reduce your original taxable capital gain tax liability by 10%.
If you hold it for an additional 2 years, the original gain liability is reduced by
another 5%. If you then hold your investment for another 3 years, the new
capital gain from the Opportunity Fund itself becomes fully tax exempt.
In order to take full advantage of the tax benets that Opportunity
Funds oer you’ll need to invest by December 31, 2019. That’s
because you’ll have to pay tax on the majority of the original capital
gain in 2026, regardless of whether or not you continue to hold
your investment in the fund.
Opportunity Funds allow you
to defer and reduce the capital
gains tax from the sale of any
capital asset.
TAX CUTS
& JOBS ACT CHANGE
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It’s important to note here that the
tax benet related to reductions in the
original capital gains liability is modest at
best, so rental property owners will need
to carefully weigh the pros and cons of
1031 exchanges versus Opportunity Fund
investments. It’s likely that an Opportunity
Fund investment will only be preferable
to a 1031 exchange for rental property
owners when they expect the Opportunity
Fund investment to signicantly outperform
the rental property market over the next
10 years.
You purchase a $100,000 property in 2010.
In 2019 you sell the property for $200,000 and roll the $100,000 capital gain into
an Opportunity Fund within 180 days. In 5 years, your taxable capital gain of
$100,000 invested in the Opportunity Fund is reduced by $10,000. And in 7 years
it is reduced by another 5%, reducing your original taxable capital gain by a
cumulative total of $15,000. This means you will only pay capital gains tax on
$85,000 of your original $100,000 gain.
You continue to hold the investment for another 3 years. During this time,
your $100,000 investment in the Opportunity Fund appreciates to $150,000.
Because you held the investment for 10 years, the tax on your $50,000 gain
from the Opportunity Fund investment is completely eliminated.
EXAMPLE: OPPORTUNITY FUNDS
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INSTALLMENT SALES
An installment sale, sometimes called seller or owner nancing, allows you to sell
your property to a buyer and receive payments over a predetermined number of
years. This spreads out your capital gains tax over several years and gives you an
additional return in the form of interest.
EXAMPLE: INSTALLMENT SALES
You purchase a property in 2010 for $30,000 and want to sell for $110,000 in
2018. Your AGI is $180,000 and this $80,000 capital gain will increase your AGI to
$260,000, causing you to pay an additional 3.8% net investment income tax.
Your CPA suggests selling this property using an installment sale to avoid the
3.8% tax.
You nd a buyer and sell them the property for $110,000. They put $10,000 down
and nance the remaining $100,000 over a period of 10 years, plus 6% interest.
Each year, $7,273 out of the $10,000 payment is considered a capital gain and the
other $2,727 is your return of principal. You’ll pay $1,091 in capital gains tax but
no tax on the return of principal. The interest you receive will be taxed at your
ordinary tax rate and you’ll avoid the NIIT in the current year
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USING COST SEGREGATION TO OFFSET
CAPITAL GAINS
When you sell a property, current and suspended passive losses can be used to
oset the gain from sale. If you don’t have enough current or suspended losses to
oset this capital gain, you can purchase a new property and use a cost segregation
study to create current passive losses that can oset the gain. It’s actually not as
complicated as it sounds, so let’s explore an example.
You sell a property for a $100,000 capital gain and have no current or suspended
passive losses to help oset the gain. You decide to purchase a new property
for $500,000 and have a third-party company perform a cost segregation study.
They determine that about 20% ($100,000) of the property can be depreciated
using 100% rst-year bonus depreciation.
This increase in depreciation expense causes your current losses to exceed
$100,000 and allows you to oset the entire capital gain from sale.
EXAMPLE: INSTALLMENT SALES
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With the increasing popularity of
short-term rentals thanks to Airbnb,
VRBO, and other vacation rental platforms,
it’s important to understand some of
the tax issues related to owning and
operating short-term rentals.
RENTING YOUR PRIMARY
RESIDENCE OR VACATION HOME
For the purposes of this section, we
assume you and/or your relatives stay
at your vacation home for the greater
of 14 days a year or 10% of the days
rented. If you and/or you relatives use
the vacation home for fewer than this
Key Tax Issues for Short-Term Rentals
number of days per year, then according
to the IRS, your vacation home is a
rental property instead of a residence.
14 Days or Less
If you rent out your primary residence
or vacation home for 14 days or less
throughout the year you do not have
to pay taxes on the income. Because
your income isn’t taxable, you also can’t
deduct your expenses.
If you rent your primary residence
or vacation home for more than
15 days, then you must report
your income on Schedule E of
your tax return.
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15 Days or More
However, your expenses are only deductible to the extent of your income.
Any remaining expenses will be carried forward to oset income from this activity
in future years.
Renting Out a Room in Your House
If you rent out a room in your house you can deduct 100% of your rental expenses
including advertising fees, rental agency fees and commissions, insurance, cleaning,
depreciation, repairs and other expenses related directly to the rental of that room.
You can also deduct a portion of the expenses related to your entire home (i.e. mortgage
interest, insurance, etc.) However, these are prorated based on both how long the room
was rented and the square footage ratio of the room to the entire home.
You have a three bedroom house and
rent out one of the rooms. If you rent
this room for 95 days out of the year,
its rental usage is about 26% (95/365).
Because you only rented ⅓ of your
house for 26% of the year, you can
only deduct 8.67% of the expenses
that relate to your entire home (i.e.
mortgage interest).
If the expenses related to your entire
home total $15,000 then you can only
deduct $1,300 (8.67% x $15,000).
However any direct rental expenses (i.e.
advertising fees) are 100% deductible.
EXAMPLE: SHORT
TERM RENTAL
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CONSEQUENCES OF TREATING YOUR SHORT-TERM RENTAL
AS A BED & BREAKFAST
In general your short-term rentals are reported as passive rental activities on
Schedule E of your tax return unless you provide “substantial services” to your
guests. Substantial services include services found in a hotel or bed & breakfast
such as providing meals, daily cleaning, maid services, travel arrangements,
vehicles or bikes, and other services commonly found in a hotel.
Note that merely providing light amenities like soap or towels is unlikely to rise to
the level of “substantial services” because it doesn’t make up 10-15% of the total rent
paid by your guest.
However, if you do provide substantial services to your guests, your short-term
rental activity is no longer considered a passive rental activity. Instead it is considered
an active business, reported on Schedule C, and becomes subject to the dreaded
self-employment tax of 15.3% on top of your ordinary income tax liability.
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The Tax Cuts & Jobs Act of 2017 introduced a new 20% pass-through deduction
allowing certain business owners to deduct 20% of qualied business income if
your taxable income is below $157,500 if single or $315,000 if married. Should your
taxable income be above these thresholds, a complicated calculation will be used
to determine the amount of this deduction. Luckily your tax professional or tax
software will handle that for you.
SAFE HARBOR FOR LANDLORDS
If you still have taxable income from your rental properties after following the strategies
explored in this guide, you may qualify for the 20% pass-through deduction under the
following safe harbor, which requires that ALL conditions are met:
• The property is held directly by the individual or through a disregarded entity by the
individual or passthrough entity seeking the pass-through deduction (e.g. a person
who owns a single-member LLC that holds a rental property qualies).
20% Pass-Through Deduction
The 20% pass-through
deduction allows certain
business owners to deduct
20% of qualied business
income if taxable income
is below $157,500 if single
or $315,000 if married.
TAX CUTS
& JOBS ACT CHANGE
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• Commercial and residential real
estate may not be part of the same
enterprise.
• Separate books and records are
maintained to reect income and
expenses for each rental real estate
activity or enterprise (a separate
real estate enterprise may constitute
multiple properties as long as it is all
commercial or all residential).
• 250+ hours of rental services are
performed for the enterprise
(see detail below).
• You maintain contemporaneous records,
including time reports or similar
documents, regarding: a) hours of all
services performed, b) description of all
services performed, c) dates on which
such services are performed, and d)
who performed the services.
Rental services include advertising to
rent, negotiating and executing leases,
verifying tenant applications, collection
of rent, daily operation and maintenance,
management of the real estate,
purchase of materials, and supervision of
employees and independent contractors.
Services performed by owners or
employees, agents, or contractors all
count toward the 250 hours.
Note that even if your rentals don’t
meet the criteria for the above safe
harbor, that doesn’t necessarily mean
they won’t qualify for the 20% pass-through
deduction. Regardless of whether your
activity qualies for the described safe
harbor, if you plan on taking this deduction,
you’ll have to issue Form 1099 for all
independent contractors to which you
paid over $600 during the year.
Rental property owners are generally
not required to le or send 1099s to
independent contractors unless you plan
to take the 20% pass-through deduction,
provide substantial services to guests, or
qualify as a real estate professional for
tax purposes.
Rental property owners are
generally not required to le
or send 1099s to independent
contractors unless you plan
to take the 20% pass-through
deduction, provide substantial
services to guests, or qualify as
a real estate professional for
tax purposes.
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A casualty loss is considered a “sudden,
unexpected or unusual event” that
causes property damage or loss.
These events commonly include:
Casualty Losses
Hurricanes
Accidents
Earthquakes
Vandalism
Fires
Floods
Volcanic Eruptions
Terrorist Attacks
If one of your rental properties is completely destroyed in one of the above scenarios,
the amount of the loss you can claim is equal to your adjusted basis in the property.
If you receive a reimbursement from your insurance company for exactly the amount
of your property’s adjusted basis, then you recognize no gain or loss. If the reimbursement
is more than your adjusted basis, then you must recognize a gain. If it is less, then you
recognize a loss in the amount of the dierence.
In the event of a gain, the good news is that you can avoid recognizing a gain by
simply reinvesting the proceeds into a property that is “similar or related in service
or use”. You have two years from the end of the tax period in which the gain was
received to nd a suitable replacement.
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Your rental property has an adjusted basis of $114,000 in 2018. A wild re
strikes, completely destroying the property.
In Scenario A, the insurance company cuts you a check for $114,000. No loss or
gain is recognized. In Scenario B, the insurance company cuts you a check of
$126,000, the property’s fair market value (FMV). You would have to recognize
a gain of $12,000.
However, you purchase a similar replacement property that cost $126,000 in
2019. In this case, you do not have to recognize the gain, but your basis in the
new property would be $114,000, the adjusted basis of the original property.
EXAMPLE: CASUALTY LOSSES
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This guide should equip most rental property owners with basic tax strategies
needed to minimize next year’s tax bill. It’s also a great source of ideas and possible
scenarios to explore with your CPA. This is not an exhaustive list of all available real
estate tax strategies and there may be additional actions you can take to further
reduce your tax liability.
For more information on how the strategies discussed in this guide might apply to
your specic situation, and tax compliance in general, we recommend consulting
directly with your CPA. Also see the ocial guidance provided by the IRS, other tax
content developed by Stessa, and further resources available via The Real Estate CPA.
While reasonable eorts were taken to furnish accurate and up-to-date information, we do not warrant that the information contained in
and made available through this guide is 100% accurate, complete, and error-free. We assume no liability or responsibility for any errors
or omissions in this guide.
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Meet Stessa
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Get time-saving tools that make
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Save time on income
& expense tracking
Link your bank accounts to Stessa
and transactions update in real-time.
Categorize transactions into tax-ready
categories for easy reporting.
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receipt capture
Keep track of and scan receipts right
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reads, categorizes and stores them for
you - no more data entry!
Keep your data safe with
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Designed from the ground up with
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Built by rental investors
for rental investors
Stessa was built from the ground up
with rental investors in mind. We take
care of all the tedious tracking and
reporting details so you don’t have to.
AUTOMATIC TRACKING & REPORTING
FOR RENTAL OWNERS
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Stessa gives the millions of real estate investors with
single-family rentals and multifamily buildings a powerful
new way to track, manage, and communicate the performance
of their real estate assets. Tracking rental property nances
and monitoring performance used to be time-consuming
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get started with a free account, go to Stessa.com.
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This content was created
by Stessa in partnership
with The Real Estate CPA.
Thomas Castelli, CPA is
a Tax Strategist and real
estate investor who helps
other real estate investors
keep more of their
hard-earned dollars in their pockets, and out of the government’s.
The Real Estate CPA is a 100% virtual accounting rm that
helps individual real estate investors, syndicates, and private
equity funds save thousands in taxes and grow their business
with outsourced accounting and CFO services. While traditional
CPAs will take on clients across numerous industries and
become “generalists,” we only service real estate investors or
business owners in the real estate industry. We eat, breathe,
and live real estate!
