3 Tax Tips for Independent Real Estate Investors

As most LoopNet readers are probably aware, there are three principal financial advantages to investing in real estate:

• Rental income.
• Appreciation.
• Tax benefits.

The first two benefits are clearer, easier to understand, and quite frankly, more exciting than the third. Taxes are a complex subject, and developing an optimal tax strategy doesn’t feel like an investment win in the same way that achieving an outstanding return does; after all, you’re not gaining something, but rather, preventing yourself from losing it.

Nonetheless, if you’re not maximizing the tax benefits of your rental property investments, you’re missing out on a significant opportunity.

There are innumerable strategies an investor can employ to augment their property tax deduction. In this article, we’ll focus on three tax tips that are relatively simple to implement, but can provide notable benefits to small landlords.

When it comes to maximizing your tax savings, lowering your income is king and there are a few Internal Revenue Code (IRC) clauses that excel in accomplishing that task. Two of the most important are bonus depreciation and the de minimis safe harbor deduction.

Bonus Depreciation

Depreciation allows landlords to reduce the value of their property over time in the eyes of the IRS. For practical purposes, this means real estate investors are able write off part of the cost of their investment each year as an expense.

Improvements on land for residential real property depreciate over a 27.5-year period, and for commercial property it’s 39. In addition, each unit of real property within the building has its own depreciation schedule, all of which can be found in IRS publication 946 (jump to page 29 for thorough definitions and useful life periods of various classes).

Now, depreciation is great, but it can take a long time. A refrigerator, for example, has a depreciation lifespan of five years. If you’re using straight line depreciation and you spent $1,000 on a new one, you could only take a $200 depreciation expense each year — not enough to move the needle much on your income. That’s where bonus depreciation comes in.

Bonus depreciation enables landlords to depreciate more of the value of an asset in the year it’s purchased than provided for in the IRS’ straight line depreciation schedule.

Further, bonus depreciation isn’t limited to appliances or other purchases, but can be applied to other enhancements as well. Running new plumbing, adding carpet, cabinetry, etc., can all be treated with bonus depreciation. However, there is some nuance as to whether the upgrade is considered to be an essential part of the building’s operation (in which case it would depreciate over 39 years) versus something that is a unique enhancement, and it’s advisable to speak with a tax advisor to understand how your particular expense would be regarded.

The Tax and Jobs Act of 2017 increased bonus depreciation from 50% of the total value of qualified property to 100%. It also expanded its range to include used assets (as long as you purchased it for the first time that year). This means that if you purchase a couch on eBay for $1,000, you can now depreciate its full value that same year, lowering your income on your rental property by a corresponding amount. Bonus depreciation allows you to accelerate the tax advantages your rental property offers and provides additional liquidity for your next investment.

De Minimis Safe Harbor Deduction

Depreciation deferral of all kinds does have one drawback: it must be recaptured at the time of sale. By way of example, let’s say you purchased a property for $100,000 and over a three-year period accumulated a total depreciation expense of $30,000. If you sold the property for $150,000 in year three, you might think you’d only be subject to capital gains taxes on your $50,000 profit over the purchase price. However, the recaptured depreciation brings your total tax liability to $80,000.

For most investors, capital now is better than capital later, so in the majority of circumstances, you want to accelerate depreciation as much as possible. But it’s still important to bear in mind that you will eventually pay taxes on that money. Current expenses, or deductions, on the other hand, lower your taxable income and are never recaptured. That means no tax on that income now, or in the future.

Here’s a basic example to illustrate the distinction between current expenses and improvements: if you decide to add a small parking garage to a commercial building, it is considered an improvement to your property and therefore, would be capitalized and depreciated over many years. After a few years, if the paint separating the parking spots faded, repainting the lines would be treated as a current expense. You’re not improving the property; you’re bringing it back to its default state. Generally speaking, improvements are depreciated, while maintenance is deducted.

One of the most powerful ways to maximize your deductions is the de minimis safe harbor clause. The de minimis safe harbor clause allows you to deduct purchased assets and components costing less than $2,500 in the year they were purchased as current expenses. So, in the eyes of the IRS, they are no longer considered improvements.

This includes any tangible real or personal property (appliances, cabinets, rugs, carpets, etc.) and individual components acquired to repair or enhance a unit of property (e.g., a sink for a bathroom). You cannot, however, divide something that is clearly a single asset into multiple components. For example, if you purchase a high-end refrigerator for $3,000, you can’t say the $500 refrigerator door is separate and qualifies under the de minimis deduction. Accordingly, when making purchases, keep in mind that $2,500 maximum to realize these benefits.

The de minimis deduction and any similar current deductions are, obviously, highly beneficial. They offer the benefit of depreciation without the drawback of future tax liability. In most situations, you’ll want to leverage this clause to the greatest extent possible. However, there are some situations in which it is advantageous to refrain from taking these deductions. For this reason, it’s critical that you understand how your tax strategy fits into your larger business objectives.

Conventional real estate investment and tax strategy are, in some respects, a bit at odds with one another. In order for a bank to give you a loan for a property, they want to see that your personal income far exceeds your debt and your losses (this is called your debt-to-income ratio, or DTI).

The DTI is a way for the bank to feel confident that you’ll be able to cover the mortgage on the investment property even if you are unable to secure tenants. As a general rule of thumb, commercial real estate lenders are typically looking for a DTI less than 43% (e.g., you have under $2,500 in monthly debt, but earn $6,000 per month before taxes).

Purchasing a rental property, however, gives you access to notable tax advantages that can affect your debt-to-income ratio in some potentially unanticipated ways. The federal government is interested in stimulating growth and, in an effort to do so, has crafted the federal tax code to enable investors to defer or even eliminate taxes by significantly reducing reported income. This is advantageous as it pertains to your tax liability. However, this attribute could suddenly become a detriment when you attempt to secure financing for your next investment.

For example, imagine a scenario wherein that $24,000 loss you took on your other rental properties has reduced your income below the 43% DTI threshold. If you had $2,500 in debt previously, you now need to demonstrate nearly $10,500 in gross monthly income.

Now, there’s a key distinction to make here. Property that is depreciated — via bonus depreciation, straight line depreciation or any other depreciation method — does not negatively impact your DTI. The lender will add your depreciation expense back into your income.

An issue can develop when you deduct property costs as a current expense via clauses like the de minimis. As we mentioned above, deductions like this are incredibly useful and generally worth pursuing. However, if you’re an investor without a great deal of income, maximizing your deductions may push you across the critical 43% DTI level.

The key here is understanding your income, your tax position and aligning your tax strategy with your business and investment goals. If you know you already have a pretty high DTI, but that you want to continue purchasing rental properties (particularly rental properties that require capital improvements), it may be best to forego current deduction opportunities in favor of depreciation.

This is perhaps the most important tip for a small investor: hire a certified public accountant that specializes in income and real estate. Rules change, codes are updated and your tax strategy evolves. A CPA will provide you with the flexibility and knowledge you need to feel confident that your tax approach not only aligns with your goals as a real estate investor, but does so within the constraints of current laws and regulations.

For small independent landlords that self-manage their properties, it can be tempting to forego the expense of a CPA. But you should think of your future CPA like an expert subcontractor. Sure, you may be able to navigate your way through some new ductwork, but if you bring in the pro, it will save you time and money in the long run. The same principle applies to your taxes.

And it’s not just peace of mind or potential tax savings that a CPA can provide. A knowledgeable CPA can offer guidance, expertise and a network of connections that will increase your acumen and grow your business.