Tax Traps for New Real Estate Investors
Below is a MRR and PLR article in category Finance -> subcategory Taxes.
Tax Traps for New Real Estate Investors
Real estate is a valuable addition to any investment portfolio, but it's essential to steer clear of common tax pitfalls. Stephen L. Nelson, a CPA and bestselling author, shares insights into avoiding these traps.
Passive Loss Limitation
New real estate investors often find themselves burdened by confusing tax rules. A significant trap is the passive loss limitation. While real estate may appear to lose money on paper due to depreciation, these losses can often only be written off if you show positive passive income overall.
For example, if a $275,000 rental property breaks even on cash flow, you might benefit from a $10,000 annual depreciation deduction, potentially saving $2,800 in taxes if your rate is 28%. However, these deductions aren’t always usable unless specific conditions are met.
Loopholes to Consider
1. Active Real Estate Investor: If your adjusted gross income is below $100,000, you can write off up to $25,000 of passive losses annually. This benefit phases out between $100,000 and $150,000.
2. Real Estate Professional: The passive loss limitation does not apply if you spend at least 750 hours per year and over 50% of your working time as a real estate agent, broker, property manager, or developer.
Capitalization of Improvements
A frequent mistake by new investors is assuming improvements can be written off immediately. Some, like repairs and maintenance, are deductible in the year they're made. However, enhancements that extend a property's life or improve utility must be depreciated over 27.5 years for residential, or 39 years for non-residential properties.
Investors often misunderstand this rule, mistakenly expecting immediate tax deductions for significant improvements. To sidestep this issue, aim to maintain the property regularly with items like repainting and carpeting which may be deductible immediately, subject to passive loss rules.
Missing the Section 121 Exclusion
A common misstep is turning a primary residence into a rental property instead of selling it. This choice can lead to losing the Section 121 exclusion, which allows you to exclude up to $250,000 ($500,000 for joint filers) of gain from taxable income if you've lived in the home for at least two out of the last five years.
By converting a primary residence to a rental, you risk turning tax-free gains into taxable ones if you fail to sell within three years. If your home has not appreciated, there's no loss of exclusion. However, if it has, selling it when moving out allows you to reinvest tax-free proceeds into another rental.
By understanding these tax traps, you can make informed decisions and enhance the profitability of your real estate investments. Always consider consulting with a tax advisor to tailor strategies to your specific situation.
You can find the original non-AI version of this article here: Tax Traps for New Real Estate Investors.
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