Avoid Tax Traps: Attorney Shares Essential Tips For Rental Property Owners

Summary

In this informative video, Tax Attorney Amanda Wynalda joins Toby Mathis to discuss common tax pitfalls faced by real estate investors and rental property owners. They cover crucial topics such as the importance of taking depreciation, accelerating it through cost segregation studies, and utilizing bonus depreciation. The conversation also explores strategies for converting passive losses into active ones, the benefits of establishing real estate professional status, and the advantages of 1031 exchanges. Additionally, they caution against the premature gifting of property and the potential tax implications of holding appreciable property within S corporations and C corporations.

Takeaways

• 📚 Depreciation is often overlooked by rental property owners, but it's crucial to take it to avoid paying depreciation recapture tax when selling the property.
• 🔄 Accelerating depreciation through cost segregation studies and bonus depreciation rules can significantly reduce tax liabilities by allowing for faster write-offs of property costs.
• 🏢 Real estate professionals can turn passive losses into active losses by meeting certain criteria, allowing these losses to offset active income like salary.
• 🔄 The short-term rental loophole allows property owners to transform passive losses into active ones by renting properties short-term and materially participating in the rentals.
• ⚠️ Using a property management C corporation can provide tax benefits, despite common misconceptions about double taxation.
• 🔄 1031 Exchanges are a powerful tool for deferring capital gains and depreciation recapture taxes when selling and buying 'like-kind' investment properties.
• 🏡 Turning a personal residence into a rental property can jeopardize tax-free gain exclusions; instead, selling to an S corporation can increase cost basis and maintain tax benefits.
• 🎁 Gifting property to children during one's lifetime can be a mistake, as it may lead to higher tax liabilities due to the loss of step-up in basis benefits.
• 💼 Holding appreciable property in an S corporation can be beneficial for certain strategies, but it's not always the best choice for holding rental properties due to potential tax implications.
• 🏢 C corporations are not ideal for holding rental properties due to the flat tax rate on property sales and the double taxation issue when distributing profits.
• 🚫 Many property owners make the mistake of not using available tax strategies, which can result in leaving significant tax savings on the table.

Q & A

Why is depreciation often overlooked by rental property owners?

Some rental property owners avoid taking depreciation because they fear having to pay depreciation recapture tax at a higher rate when they sell the property. However, they must understand that even if they don't depreciate the property, they still have to pay depreciation recapture.

What is the purpose of a cost segregation study in real estate?

A cost segregation study is used to accelerate depreciation by separating the property into different categories based on their useful lives, such as 5, 7, 15, and 1/2 years, or 15 years. This allows property owners to depreciate certain components of the property more quickly than the standard 27.5 or 39-year timeline.

How can bonus depreciation rules benefit rental property owners?

Bonus depreciation rules allow rental property owners to take the full depreciation of certain property types in the first year, rather than spreading it out over the asset's useful life. This can significantly reduce taxable income and provide immediate tax benefits.

What is the significance of claiming real estate professional status?

Claiming real estate professional status can transform passive losses into active losses, which can then be used to offset active income such as W2 wages. This requires the individual to materially participate in the real estate activities for more than 50% of their working time.

What is the short-term rental loophole and how does it work?

The short-term rental loophole allows property owners to materially participate in their rentals by renting out the property for seven days or less on average. If they meet certain criteria, such as spending at least 100 hours per year on the property, they can turn passive losses into active losses that can offset other income.

Why might a property management C corporation be beneficial for rental property owners?

A property management C corporation can be beneficial because it allows for income shifting to an entity that has a lower tax rate (21% post-Tax Cuts and Jobs Act). Additionally, C corporations offer tax-free reimbursements for certain expenses, such as health, medical, and vision expenses.

What is a 1031 exchange and how does it help rental property owners?

A 1031 exchange is a strategy under IRS code section 1031 that allows rental property owners to defer capital gains and depreciation recapture taxes by exchanging their property for a 'like-kind' property. This can be used to upgrade or expand their rental portfolio without immediate tax liability.

What are the tax implications of turning a personal residence into a rental property?

Turning a personal residence into a rental property can impact the 121 exclusion, which allows for tax-free gain on the sale of a primary residence up to $500,000. If the property is rented out instead of being sold, the owner may lose this exclusion and face tax liabilities when eventually selling the property.

Why is it generally not advisable to gift property to children while the owner is still alive?

Gifting property to children while still alive results in a transferred basis, meaning the children inherit the property at the same value as the parent's basis. This can lead to higher capital gains taxes when the property is eventually sold. It's usually better to let the property benefit from a step-up in basis upon the owner's death, which sets the basis to the property's market value at the time of the owner's death.

What are some potential issues with holding appreciable property in an S corporation?

While an S corporation can provide asset protection and tax benefits, holding appreciable property in an S corporation can lead to complications when trying to refinance or in the event of a lawsuit. Additionally, if the property needs to be removed from the S corporation, it may be treated as a taxable distribution to the shareholder.

Why might holding appreciable property in a C corporation be a bad idea?

Holding appreciable property in a C corporation can lead to a higher tax rate when selling the property because the C corporation's flat 21% tax rate does not benefit from the preferential tax treatment given to long-term capital gains on rental property. Additionally, extracting the money from a C corporation may result in double taxation, either through dividends or as a taxable event.