As we steadily approach the 2017 tax season, every tax payer has one question: how do I reduce the amount of tax I have to pay? Whether you’re learning how to file taxes for the first time or simply looking for tax tips in 2017 that help reduce your fiscal burden, most are simply looking for a way to hold on to more of what they earn.
And that’s where tax loopholes come in.
The term tax loophole may carry negative connotations, images of off-shore accounts and fake corporations. The ever-complicated tax code offers many avenues, or “loopholes,” for investors to utilize their money in a constructive way (and keep more of at the end of the year).
Here are four legal tax loopholes active real investors can use to save money this 2017 tax season.
Note: All of the information provided is strictly for educational purposes. Be sure to consult a tax professional before implementing any tax strategy.
Legal Tax Loopholes Real Estate Investors Can Use in the 2017 Tax Season
1. Active Participant Loophole
There may be no more powerful area of small business deductions for an investor than depreciation. Although buildings are subject to wear-and-tear over time, properties, in most cases, gain value every year. That, on top of the earnings you get from your rental property, means depreciation is only considered a loss on the books. In reality, you are likely earning money; that’s what make depreciation so powerful.
Congress has, however, partially done its best to diminish this strategy via the “passive loss limitation rule” under Section 469. It states that depreciation-type (i.e. only “on paper”) losses do not cover taxes you must pay for earned income (e.g. wages) or investment income (e.g. interest, dividend, capital gain).
A work around for this form of tax is a strategy called the active participant loophole.
How It Works
The active participant loophole allows you to use depreciation write-offs, given that your gross annual income is less than $100,000. If you’re at this income level, you can write off passive real estate losses of up to $25,000 on your tax return.
The downside to this — and the reason why highly-taxed real estate investors do not gravitate instantly toward this loophole — is that the write-off gradually phases out once you start earning more money.
For instance, if you earn more than $100,000, but less than $150,000, you only get a portion of the $25,000 deduction. Anything more than $150,000 means you are not qualified for the deduction.
The active participant loophole requires you to actually work on your property to be considered an “active” investor. It doesn’t require much work, mind you, other than picking property managers or approving your tenants. But it’s a great loophole to explore, especially early in your investing career.
2. Sidestep Loophole
The sidestep loophole is another way you can avoid the passive loss limitation rule. For this, you need to be designated as a “real estate professional.”
How It Works
Although there is no need to pass a test or apply for licensure to be a real estate professional, you (or your spouse) need to log at least 750 hours per year of work on your real estate properties.
And by “work,” this means being either the developer, agent or broker, or property manager. If you work two days per week managing your rentals, that can also count as being a property manager.
Passive losses do not apply to real estate professionals. Meaning, using this strategy allows you to shelter your income or investment income from possible tax liability.
For instance, if your spouse earns $600,000 annually and you (the real estate professional) lose $300,000 per year, your household gross taxable income would register at $300,000. (The implications of this are quite powerful.)
There are a few things you need to keep in mind for this to work:
- You need to keep a good, detailed calendar of your hours working on a property.
- If you own more than one property, and cannot log 750 hours for each property, specify you want your properties to be treated as a single real estate entity. The hours of work rendered would then be considered a single activity.
- Always consult with a tax adviser regarding this, or any other tax strategy.
3. Safe Harbor Loophole
A loophole that especially benefits residential landlords, and is great for tax advice for small business owners of all shapes and sizes, is the safe harbor ruling which views your routine maintenance expenses as deductible in a single year, even if the maintenance qualifies as improvements.
How It Works
Routine maintenance refers to recurring work done to keep a property in an efficient and operating condition. The IRS would consider your qualification, under this rule, given that the work entails:
- Replacement of damaged or run-down parts
- Inspection, testing, cleaning, and/or reconditioning of the building
For instance, an HVAC system needs to be maintained every four years. The expenses that you incur during this time would be added to your deductions for that year.
There are a couple of limitations to the safe harbor loophole:
- 10-year rule: The maintenance needs to be performed more than once every 10 years. If it turns out the work you did does not require to be done more than once every 10 years, you need to prove your initial expectations of the work were reasonable.
- No betterments or restorations: If you allow a building (or any of its parts) to fall into a broken-down state, in such a way that simple repairs will not fix it, then the IRS will consider the work a restoration project. The safe harbor ruling does not cover major remodeling, betterment, or restoration work. It also does not cover maintenance work that can be attributed to the previous owner; it has to be during your use of the property.
4. The Last Tax Loophole You’ll Ever Need
This is definitely one set of small business tax tips you hope to never use. But when you die, tax laws dictate the value of your property be “stepped up” to the value of your property in the year in which you pass. (Meaning that your heirs could avoid costly capital gains taxes.)
How It Works
If you were to sell your property today, you would be liable for the gain or appreciation of the property. This is calculated based on the value of the property currently, minus the amount you purchased it for. (i.e. Current value – value when purchased = gains).
Say your property is worth $200,000 today but you purchased it for $100,000 10 years ago. Your $100,000 gain would be subject to federal capital gains tax, not to mention your particular state tax rate. If your tax bracket requires you to pay a premium of 15% of capital gains tax and 5% state tax, you are looking at paying taxes of approximately $20,000 upon selling the property.
However, upon your passing and the property passed to someone via awill or living trust, your property’s basis value would be stepped up to its current market value. With the basis and the current market valued both at $200,000, that means your heirs are subject to zero taxable gain.
Play Every Ace
As we said earlier, it is both an ethical and legal requirement that you pay your fair share of taxes, as a residential redeveloper. By utilizing specific strategies, or loopholes, you can ensure your 2017 tax season is more pleasant, productive (and possibly profitable) than you ever thought possible.