I just finished “Every Landlord’s Tax Deduction Guide” by Stephen Fishman of the Nolo publishing company. This was the Idiot’s Guide to Cover Your Assets. Let me share the best lessons.
The government is gracious enough to only take money out of your pocket. By that I mean, if you charge someone $5 for a sandwich, and it costs $5 in ingredients and labor to make the sandwich, no money is going in your pocket. The government is happy to let you fill your days with these “wash sales.” The first half of the equation is your money coming in, your income. That is rent and the sale of houses. It also includes a security deposit if you keep it as the last month’s rent, late fees, parking fees, and laundry fees. More on the second half of the equation later.
A sole proprietorship is a one man, one house relationship. Just as God intended.
More than one person contributes funds, services, and property. Partners have equal say in managing the business.
Just like a regular partnership, except there is a general manager that is actively engaged in the day to day operations of the business, and limited partners that contribute funds and share in the passive gains.
A corporation is just like a limited partnership, except that it is a distinct, separate legal entity from the individuals it represents.
The S stands for small business. A small business corporation passes the income and the losses to the owners, who must pay personal income tax.
The C stands for… The C refers to “Internal Revenue Code—subchapter “C”—under which its tax designation is described.” per https://www.forbes.com/advisor/business/c-corporation/. I had to look that up. The income and losses are not passed through and the corporation must pay taxes on the income.
Limited Liability Company
An LLC is like a regular partnership in that multiple people can contribute and gain, and it’s like a S corporation because it is a separate legal entity, and the profits and losses pass through to the owners.
Tips to not get audited
- Be meticulous. The return should look professional. There shouldn’t be any erasure marks. The papers should be neat, orderly, and clean. The math should add up. If you round up to the nearest $5000, it will look like you’re guessing. Don’t round the numbers. Your state and federal returns should match.
- Mail your return by registered mail.
- Don’t file early. The IRS has 3 years following April 15 to decide to audit you. If you get the extension to file late, the IRS will have less time to decide. You might avoid an audit through IRS indecision. (Even if you get the extension to file late, you still need to pay taxes by April 15).
- Don’t file Electronically. The IRS has to hire temp workers to transcribe data from paper returns into their database. There’s only so many hours in the day, and a ton of returns, so the data entry clerks only enter the most essential information. Additionally the IRS has to store the paperwork for X number of years, and then they dispose of it. This is good because the IRS can only audit you based on the information it has. If the information they need wasn’t important enough at the time to type up, and/or is now shredded, then you’re safe.
- If you claim a large, legitimate deduction on your return, include a Disclosure Statement with your return explaining the situation. It’s not a guarantee, but auditing is a painful and expensive process and if your explanation seems reasonable, they might not audit you.
- Report all rental income. The IRS wasn’t born yesterday. If your numbers for income seem disproportionately low, you might be flagged for an audit.
Landlord Tax Categories
Business owners differ from investors in that they are active in the operations. They interview, call, hire, fire, etc. One note, it’s possible to hire a real estate agent or management company to do the operations for you. You’re still the business owner, even if you’re not personally doing the work.
Real estate investor
A real estate investor simply puts money into a business and expects their share to increase in value, or pay dividends. They have little to no say in the operations.
Dealer in real estate
People who buy real estate low and sell high are real estate dealers. They are not particularly interested in collecting rents or dividends. It’s possible to own one house for collecting rent, and one house for flipping and selling. In this case, be very careful to keep your records straight and your receipts separate. The IRS will determine your dealer status on a property by property basis.
A person who owns rental property as a not-for-profit activity
There are three general cases when someone is considered not profit motivated:
- Renting out a vacation home that you or family occasionally use
- Renting below market rates
- Letting the property sit vacation for a substantial amount of time
Business owners and Investors can deduct many of the same big ticket items from their revenue: repair costs, depreciation, interest, travel expenses, etc.
Investors do not get the following that business owners get: Home office deduction, seminar or convention attendance tickets, $5,000 for starting up your business.
If your activity is not-for-profit, you can only deduct as much income as you made. You can’t report a loss. If you earned $6,000 in rent collected, you can only claim $6,000 in deductions. It’s only worth claiming deductions if you can itemize and they add up to more than the standard deduction.
Dealers have the worst hand when it comes to tax treatment. Their profits from sales count as ordinary income as opposed to business owners and investors whose profits are subject to capital gains which is usually much lower. They can’t deduct depreciation. They have to pay self-employment tax and medicare tax. And if that’s not bad enough, they also have to file a Schedule C.
Deducting Operating Expenses
The two golden equations to know for real estate business owners are:
- profit = revenue – expense
- tax due = profit X tax percent
If your revenue equals your expenses, then you don’t have to pay any taxes. The rent has to be at least market rate, so it’s hard to get the revenue low. This means the expenses need to be as high as possible. In order to get the expenses high, you need to re-invest in the business.
There are two main categories of expenses: operating expenses and capital expenses (aka improvements)
To be classified as an operating expense it must be all of the following:
- ordinary and necessary
- directly related to rental activity
- reasonable in amount
Operating Expenses include: office supplies, advertising, cleaning supplies, property insurance, accountant fees, mortgage interest, utilities, and most importantly, repairs.
The following are forbidden from being deducted:
- Paying government fines for parking tickets or violating city housing codes
- Bribes and kickbacks
- 2/3rd of damages paid for violating the federal antitrust laws
- Real estate exams or license fees
- Country club membership fees
- Federal income tax (haha nice try)
Repairs vs Improvement
Everyone wants to claim that an improvement is a repair. The advantage is that repairs can be classified as an operating expense, and thus deducted immediately. Improvements have to be depreciated. Depreciation is similar to amortization in the sense that the cost is spread out over time. The general rule of thumb is that repairs bring the structure back to the original state before the destruction and improvements make the house better than before.
For instance, if your roof leaks and it’s patched up, it’s considered a repair. If the roof leaks and you replace the old shingles with titanium shingles, then it’s an improvement, even though in effect it has only fixed a leak.
Things that are improvements even though we’d like them to be classified as repairs
There is a gray area the size of the moon when it comes to repairs. Ultimately it boils down to interpretation of tax code, which is best left to tax attorneys and the IRS. That being said, here is a list of things that are generally considered improvements even though we’d like them to be classified as repairs:
- All major appliances (fridge, stove, dishwasher, air conditioner, water heater, etc.)
- Bringing the house up to code (even if the government forces you to do it)
- Replacing a cracked brick wall with a new brick wall
- Replacing a worn out wood floor with a concrete floor
- Removing an environmental hazard (lead, asbestos, radon, mold, etc.)
These costs have to be spread out over several years instead of all at once.
General Plan of Improvement and the Accidental Repair Plan
The General Plan of Improvement is, I swear, one of those things the IRS invented to ensnare unsuspecting landlords and take all of their money. Actually, I think they purposefully leave it ambiguous so that landlords don’t try to game the system. It goes as such: if you planned to, or it looks like you planned to make several repairs all at once, then actually you made a bunch of improvements. And then you’d have to depreciate the cost over several years instead of all at once. And if you accidentally deduct your expenses all at once and the IRS catches you three years later, you will owe back taxes.
There is a simple trick to getting around this rule, and I call it the Accidental Repair Plan. To implement said plan, spread out repairs over as long of a time period as possible, several years if you can. Hire out the work to a variety of contractors. Make sure all of the invoices reference “repair of X” instead of “improved X.” If possible, have a tenant. It’s nice to have a tenant because then you have income while you are incurring expenses, but it’s not always convenient to plan around their schedule, which is why many landlords unsuspectingly use a General Plan of Improvement between tenants. Of course, don’t be a slumlord. Get the house fixed up and habitable in a timely manner, for the sake of all that is decent and civil.
Depreciation = Tax Free Over Time
Since repairs are considered operating expenses, they are deducted the same year that they occur. Since property that wears down, such as houses, fences, new roofs, and lawn mowers are not operating expenses and instead are considered improvements, the deductions are spread out over several years, depending on the category of improvement. For instance, a house depreciates over 27.5 years.
What’s the Basis?
The first step to calculating how much you can depreciate is determining the “basis” of the improvement. The basis is the total amount that you paid for it. For a house, the basis includes the: cost of the property, legal fees, transfer taxes, etc. The land that the house was built on does not wear down, so it cannot be depreciated, and is not included in the basis. There are other ways of calculating the basis, but they are much more complicated.
The “value” of property generally follows a line sloping down to the right. Let’s say it goes down by $100/year. You can deduct $100 each year until the value hits zero. There are other lines, some are more advantageous by being steeper at the beginning (more money deducted and thus less taxes paid that year). This is one of the most complicated parts of tax law, so I will leave it to the tax attorneys and the IRS.
And they lived happily ever after
The tax law only gets more and more complicated. It’s fractal in nature. Every law has a sub-law, and the sub-law has an exception, and the exception has an interpretation from the IRS, which was overruled by the tax court, etc. And it’s like that all the way down to the metaphysics of property rights (do property rights physically exist?). But, that is a topic for the sequel, Every Landlord’s Metaphysics of Property Rights Guide.