Best Real Estate Entrepreneur Tax Deductions
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April 10, 2023

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One of the most attractive things about becoming a full-time real estate entrepreneur is the tax advantage that comes with it.

Those who can reasonably say they are full time in the real estate business can qualify for massive deductions like depreciation to reduce other income earned.

Below we describe this and other effective ways to reduce the tax you owe as a real estate entrepreneur—simple tax strategies for real estate investors.

NOTE: This article should not be taken as a form of tax advice. We highly recommended to seek the opinion of your own tax, legal, and/or accounting advisors before making any decisions.

How is rental income taxed?

There’s a reason many people equate real estate investment with tax shelters.

If applied correctly, the U.S. tax code can be very advantageous for those in the real estate business. Multitude deductions can be applied legally to decrease the taxes owed by real estate entrepreneurs.

Understanding the taxation of rental income

The rental income tax system applies to those who earn money through renting their property to tenants. Understanding how this type of tax works is important to accurately file your taxes and ensure that you comply with the law.

The Internal Revenue Service defines a rental property as a single residence, such as a house, apartment, condo, mobile home, or vacation home, owned by an individual and rented out for 15 or more days per year.

The income produced by your rental property is subject to taxation as a standard income on your tax filing. For instance, if the net rental income for the year totals $10,000 and you fit into the 22% tax bracket, you would be required to pay $2,200 in taxes.

Owning an investment property that gives a steady monthly income is permissible despite reporting a loss on a tax return. Property owners, including yourself, must adhere to all the IRS guidelines for renting out residential property.

Determining the amount of rental income and the costs associated

There are a few kinds of income that a rental property can generate:

  • Usual rent payments
  • Prepayments (like first and last month)
  • Monthly payments for additional fees like pet costs, parking, or rental of appliances
  • An extra charge or penalty for terminating a lease
  • Expenses taken care of by the tenant which would usually be done by a vendor, such as gardening
  • A part of the security deposit that isn’t given back to the tenant, for instance, to pay for damages caused by the tenant

When a security deposit is refundable, it isn’t considered income since it is meant to be returned to the tenant after the lease. It’s often recorded on the balance sheet as short-term debt.

If your tenant does not meet the conditions of the agreement and you keep the security deposit, it becomes taxable income for that specific tax year.

Some of the most common and beneficial deductions associated with your rental property can be subtracted from all the income you’ve earned throughout the tax period.

That includes:

  • Expenses associated with repairs and upkeep
  • Supervision and rental charges
  • Gardening charges
  • Utilities like water, garbage disposal, or pest control
  • Insurance premiums
  • Interest on the mortgage
  • Sales or rental taxes
  • Property taxes
  • Fees for a homeowners association or condo
  • Professional and legal costs, including your accountant or lawyer

To calculate your taxable income before depreciation, you must take all of your expenses away from the income earned.

A gross income of $18,000 per annum, minus the expense of having and running the property at $8,000, would leave you a taxable income before depreciation of $10,000.

Estimating the depreciation of assets

The IRS Publication 946 provides an in-depth description of how rental property depreciation functions—but here’s a quick summary.

It should be noted that “depreciation” is a non-cash expense that can be subtracted from the net income of your rental property to compensate for its depreciation or deterioration.

The IRS enables individuals to depreciate the residential rental property over 27.5 years. Therefore, if you paid $125,000 for a single-family rental home and the land’s worth is $25,000, your yearly depreciation deduction is $3,636.36 ($100,000 / 27.5 years).

The worth of the land is not considered because the IRS presumes that the land does not depreciate.

The amount of taxable income after deducting the depreciation expense of $3,636.36 from the pre-depreciation taxable income of $10,000 is $6,363.64.

The depreciation expense has resulted in significant tax savings of $800. Rather than paying the original $2,200 with the same 22% tax bracket, the cost is now reduced to $1,400.

Using depreciation to reduce regular income

Perhaps the best aspect of depreciation for full-time real estate investors is that it can reduce other income earned during the year.

Not everyone can count all their depreciation in the same year. You need to qualify as a real estate professional, meaning you

  • Spend at least 750 hours per year in real estate
  • Work more time in real estate than any other occupation

These individuals can use real estate depreciation to reduce or eliminate other income and pay less taxes as a result. If you’re not a full-time investor, depreciation can only be used to offset rental income.

How does zero income affect mortgage applications?

If you’re a real estate investor, you could feasibly have zero income for the year. If you apply for a mortgage, the lender can only use adjusted gross income. Obviously, you can’t qualify for a home on zero income.

New creative loan programs allow you to qualify without tax returns.

  • DSCR loan: Qualify using the cash flow from the property itself, not personal income.
  • Bank statement loan: Qualify using bank deposits over 12 or 24 months.
Check your eligibility for a self-employed mortgage .
  • Self-employed mortgage programs
  • Refi, Cash-Out Refi, and Purchase
  • Primary, Second, Investment Homes
  • No tax returns

QBI tax break

Real estate investors are eligible for a tax break referred to as the Qualified Business Income Deduction (QBI) or as Section 199A, which is a deduction for pass-through income.

The QBI deduction allows taxpayers to take an extra deduction of up to 20% of their qualified pass-through business income after deducting all their operating expenses, ownership expenses, and depreciation.

Those who own sole proprietorships, partnerships, S corporations, and certain trusts and estates might be eligible for the qualified business income deduction.

To ensure that you get all the deductions you’re eligible for, it is advisable to look at what the IRS says about the QBI deduction or talk to a tax advisor, as the regulations can be quite complex.

Possessing assets through a self-directed IRA (SDIRA)

A SDIRA, or self-directed individual retirement account, is a type of individual retirement account (IRA) that can hold various alternative investments normally prohibited from regular IRAs.

A custodian or trustee administers this account, but the account holder directly manages it, hence the “self-directed” part of the name.

You can deposit money into an SDIRA and create a legally recognized entity (such as an LLC) to buy, own, and manage your investment properties. The self-directed IRA then puts the money into the LLC as your chosen investment.

Self-directed IRAs are available in traditional IRAs (where tax-deductible contributions are made) and Roth IRAs (where tax-free distributions are taken). These IRAs are ideal for experienced investors who want to diversify their portfolio in a tax-advantaged account.

The main difference between self-directed IRAs and other IRAs is the range of investments that can be held in the account. Regular IRAs limit investments to common securities like stocks, bonds, CDs, and mutual funds.

However, self-directed IRAs allow the owner to invest in a broader range of assets such as precious metals, commodities, real estate, and other alternative investments.

Therefore, self-directed IRAs require more effort and research from the account owner.

Reporting your rental income on taxes

Real estate investors are required to document their profits and losses from rental properties, partnerships, S corporations, estates, and trusts on Schedule E of Form 1040 or 1040-SR.

Additionally, Form 4562 should be filled out and submitted to the IRS to report any depreciation or depletion expenses. As you expand your rental property business, you can have up to 3 properties listed on Schedule E.

If you have more than three, you must submit an extra Schedule E form.

Maintaining records

To ensure that the IRS is given accurate information, it is essential to maintain meticulous records of your property, such as rent payments, expense documents, and financial statements.

Your property manager should give you a year-end profit and loss statement that is often invaluable for your tax filing.

Be sure to review the P&L statement and consider any other costs that your supervisor may not know about, like taxes paid for your investments or trips taken to your real estate.

Furthermore, in the event of a tax audit, having precise and thorough records will demonstrate to the IRS that you are professionally running your real estate venture.

Tax strategies for real estate investors—the bottom line

If you want to succeed financially, it’s essential to understand the regulations and tax codes related to being a real estate investor. This choice is especially true when it comes to cutting your taxes on earned income.

Taxes are part of any business. Whether you run a restaurant, a daycare, or work from a home office selling widgets, you must pay taxes. Failing to take advantage of the tax strategies and deductions available to your type of business will ultimately cost you cash that you didn’t have to spend.

That’s not good business, and it’s why we’re here to help you out. If you’re self-employed and want to uncover more tax strategies that can save you money, reach out to us and let’s see what we can do.

Check your eligibility for a self-employed mortgage .

Our advise is based on experience in the mortgage industry and we are dedicated to helping you achieve your goal of owning a home. We may receive compensation from partner banks when you view mortgage rates listed on our website.

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