Are you maximizing your Rental property and Small Business tax deductions?

In America, there are two tax systems: one for the informed and one for the uninformed. Both are legal.

Judge Billings Learned Hand

I have always had a love-hate relationship with tax season… I do our our book keeping and I’m not a big fan of accounting, however I do love my tax refunds. And if you are a real estate investor or run a small business, it’s the time of the year Uncle Sam rewards you for stimulating our economy. I’m talking about tax deductions for eligible business expenses that are ordinary and necessary… A tax deduction (write- off) is an expense that you can deduct from taxable income. But you cannot claim as a business deduction what you do not know qualifies. I wrote this post as a brief overview of eligible business deductions. Some of the deductions are intuitive but others not so much. Being aware of these deductions also helps you strategize throughout the year so you can maximize your tax write offs. A few very basic pointers though, always save your receipts – hopefully electronically using one of the numerous expense management software available. And always consult with your tax preparer before claiming a deduction on your tax return.

ELIGIBLE BUSINESS EXPENSES:

These deductions are common to small business owners structured as a partnership or LLC, sole proprietors and real estate investors. I have sprinkled in this post some strategic information that I learned along the way that really shifted the way I look at business expenses.

• Business travel: cost of travel, lodging, room service, valet parking fees, tips and meals can be deductible if they are ordinary, necessary. Tip: Now something to think about – business travel can include personal days of fun sandwiched in between, as long as:
  1. a specific business purpose was planned before you leave home
  2. you engage in business activity more than 50% of the trip (travel days are considered business days by the IRS)
  3. you maintain receipts and hour logs
  4. you only deduct expenses related to the business part of the trip..
• Business use of vehicle can be deducted using Standard mileage or Actual expense method including gas, repairs, insurance and lease costs – the method you choose needs to stay the same after you place the vehicle in service. It’s really important to track your miles for business use using an app like Mileiq or Stride. Note that miles driven between home and your primary site of business are considered personal commuting miles and not business miles. Tip: If you are using your vehicle for greater than 50% business use, it meets certain criteria (most important being >6000 lbs Gross vehicle weight) and you purchased the vehicle (even if you financed it), you may be able to depreciate up to 100% of the vehicle’s cost as a business expense, please see below under Depreciation and Bonus depreciation. This can provide huge tax breaks for those buying new and used heavy vehicles for business use.
• Meals and entertainment : You can usually deduct 50% of eligible meals that are ordinary and necessary for the business including meals with your employees or clients, but meals provided for a company wide party are 100% deductible. Tip: The Consolidation Appropriations Act permits 100 percent deduction for meals for any meal expenses incurred after December 31, 2020 through December 31, 2022 as a measure to help the restaurant industry.
• Home office if it is your principal place of business and the area is used exclusively for business activities. You may use Actual expense method (portion of actual expense may be deducted) or the simplified method (5$/ sqft of office space up to a maximum of 1500$). Tip: Actual expense method usually works best as You can deduct:
  • the cost of furniture, remodeling the space, associated repairs and maintenance
  • portion of your home’s utilities, home insurance, HOA, cleaning costs, mortgage interest and property taxes (or portion of your Rent if you are renting).
• Income shifting: is a great way to save on taxes if you have kids (or parents) who are old enough to help out in the business (book keeping, filing, cleaning, modeling). Paying them through the business moves money from your high income tax bracket into their lower tax bracket. It is important to pay your kids appropriately and issue your younger kids a W2, older kids may be paid as 1099 contractors. Also remember to record their hours worked and pay. Tip: A great way to invest this money for your child’s future is in a Roth IRA where it can grow without ever being taxed. This money can be withdrawn penalty free down the road to pay for college tuition or down payment on a first home.
• Taxes paid in the course of your business: State income taxes, payroll taxes, personal property taxes, real estate taxes paid on business property, sales tax, excise taxes etc
• Tax preparation fees, accounting and attorney fees
• Advertising costs
• Insurance costs (professional liability or malpractice insurance, group health insurance, insurance on property, auto insurance and life insurance policies for employees as long as business owner is not on policy)
• Cost of setting up and maintaining entities required for your business, licensing fees etc.
• Education costs (books, seminars) when they are related to your current business
• Health care expenses if you are self employed
• Interest on mortgage and credit cards as well as bank fees,
• Moving expenses
• Salaries and benefits including retirement contributions
• Phone and internet bills, laptops and devices, supplies necessary for the business
• Qualified Business Income QBI : Taxpayers who receive business income (including rental income) through a pass-through entity like a sole proprietorship, partnership, LLC, or S-corporation can deduct as much as 20% of it.
• Depreciation: the IRS defines depreciation as ” an income tax deduction that allows a tax-payer to recover the cost or other basis of certain property.” Depreciation is one of my favorite deductions, one that all real estate investors and business owners love because once depreciation is factored in, even profitable businesses may show a loss for tax purposes. Depreciation rules allow Furniture, devices, equipment and other business assets including the building and business vehicles to be written off as a business expense over the course of their useful life; this means that you are in effect generating paper losses that then shelter your rental or business income from taxes. If you purchase depreciable property in your business, depreciating the property isn’t optional–it’s required. For example, some common time frames for deprecation are : 5 years for Computers, office equipment, vehicles, and appliances, 7 years for Office furniture, 27.5 years for Residential rental properties (only the building portion of the asset is depreciated, not land). Commercial buildings and nonresidential property are depreciated over 39 years. The IRS however, in order to incentivize a business owner to spend and stimulate the economy, permits a business owner to expense (writing off or deducting entire cost upfront) these items in the year that they are placed in service if:
  • cost of the item is less that 2500$ (De minimis safe harbor election)
  • asset is purchased (not leased) and tangible (excludes building) and used more than 50% in business (Section 179 deduction). There are additional criteria for business vehicles to qualify based on Gross Vehicle Weight GVW.
  • Tip: Bonus depreciation: is a means of accelerating depreciation for Qualified business property (useful life less than 20 years) and Qualified improvement Property (improvements made to the interior of non residential property) that is placed in service. The Tax Cuts and Jobs Act of 2017 (TCJA) permits a business to write off up to 100% of the cost of eligible property purchased after September 27, 2017 and before January 1, 2023 (50% bonus depreciation under the prior law). However, that 100% limit will begin to phase down after 2022 unless this component of the TCJA is repealed.

THE REAL ESTATE INVESTOR:

Real estate investors are eligible for the same business expense deductions as small businesses. When you purchase income producing rental real estate, the IRS allows you to depreciate the value of the building you’ve purchased as a tax deduction –but the value of the land it’s on can’t be written off. Value of the Building = Property purchase price – value of land. Land values are often available from the county database or your appraisal report. Remember:

• Depreciation must be taken every year the property is in service – it is a requirement
• Depreciation is based on purchase price of the building portion of the property, not on the current appraised value of the property (which typically increases over time)
• Residential building is depreciated over 27.5 years, commercial building is depreciated over 39 years
• Depreciation is the same if you purchased the property outright or if you took out a mortgage on the property
• Other assets within the building have different useful lives over which they may be depreciated:
  1. Carpet, flooring, appliances, Light fixtures, furniture, cabinets – 5 years
  2. Land improvements such as landscaping, fencing, sidewalks- 15 years
  3. Windows, Doors, HVAC, water heaters, countertops – 27.5 years

For example, let’s say you purchase a rental property for 250,000$ and the assessed value of the land at the time of purchase is 50,000$. Then the value of the building is 200,000$ which you will depreciate over 27.5 years (7273$ per year of write-off, irrespective of whether or not you have a mortgage on the property), which will generate a paper loss for you every year that will shelter a portion or all of your rental income cash flow from taxes.

Tip: Cost segregation and bonus depreciation are ways of accelerating your depreciation deduction by breaking down the building components into smaller assets with shorter lives and then using bonus depreciation. Talk to your CPA to see if these strategies make sense in your current tax scenario and if they aligned with your long term goals.

Improvements made to rental property: If the improvement meets criteria for (De minimis safe harbor election – cost less than 2500$), write-off may be taken entirely in the year expense is incurred. Most improvements to rental property need to be added to the depreciable value of the property if they add value to the property and are expected to last longer than a year. For example, new carpet installed for 3500$ will need to be depreciated over 5 years.

Summary of Other eligible expenses on Schedule E (that you will most likely report your rentals on) for a real estate investor include – mortgage interest, property taxes paid, insurance, property management fees, repairs and maintenance costs, HOA fees, commission paid to your realtor for leasing the property, advertising costs, operating expenses, utilities that you pay for etc. Improvements to the property may not be deducted, they have to be depreciated (Tangible property regulations).

Fees incurred during property acquisition: Some costs can be deducted in the year of purchase – prepaid mortgage interest expense, prorated property taxes and insurance premiums, association dues. Other costs must be added to the value of your property and depreciated over time – remainder of closing costs, legal fees, surveys, transfer taxes, title insurance.

Passive Activity Loss (PAL) rules state that passive losses can only be used to offset passive income. Rental activities are considered passive by the IRS and if an real estate investors eligible deductions exceed rental income (a common scenario due to paper losses from depreciation), they accrue passive losses that cannot offset earned or ordinary income. These losses carry forward and are released on sale of the property to offset capital gains or if the individual begins generates excess passive income (that is not offset by passive losses). Tip: Exceptions to this rule are when an investor has Real Estate Professional Status REPS and materially participates in the rental activity or if Modified Adjusted Gross Income MAGI is less than 150,000$ for married filing jointly.

I hope this post served as a quick reminder of what your eligible business deductions are and how you can maximize your deductions. I believe this post is particularly useful for those who started a new business or acquired a new rental property last year. Here’s to hoping your tax refund brings you one step closer to creating generational wealth…

The eyes do not see what the mind does not know.

Book Recommendations

Tax-free wealth – How to build massive wealth by permanently lowering your taxes (Rich Dad advisor) by Tom Wheelwright

Tax strategies for the savvy real estate investor by Amanda Han and Mathew Macfraland

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