Are you maximizing your tax savings in your real estate investing business? Now is a great time for you to make sure you have structured your investing operation properly, so you take full advantage of the tax benefits of being a real estate investor.
I’m a big believer in the 80/20 Rule, so these tips will cover the 80% of reducing tax liabilities for real estate investors. This won’t describe creative deductions, such as how to write-off a cruise to the Bahamas. Instead, these five powerful tips are intended to form the basis for a solid fiscal foundation, so you can pay the least amount in taxes each year.
Disclaimer: This is not intended to be accounting advice, and the author is not a licensed tax professional. Consult a CPA or other professional tax adviser for any tax or accounting advice.
# 1. Get a Good CPA
Find a competent local Certified Public Accountant (CPA) who is also a real estate investor who owns rental property, as well as buys and sells real estate for investment purposes. Ask other real estate investors in your area whom they use. Ask other CPAs if they know a CPA who is also a real estate investor.
Perhaps a local real estate investment club could point you in the right direction. It may take time to locate a winner. Be patient and persistent and avoid getting discouraged. They exist.
# 2. Hold Short Term & Long Term Investments in Different Entities
Once you have located your real estate investor friendly CPA, the first thing you should do is separate your short term investing activities (less than 1 year) from your long term investments (more than 1 year).
Wholesaling, flipping, and rehabbing are typically short-term investing activities whereas owning rental property is usually considered long-term investment activity.
The type of entity for each may be different, and your CPA will be helpful in this decision. Let your CPA help you figure out which entity structures are right for you.
# 3. Get Organized
If you’re first response to this tip is that you are not an organized person, I’ve got something important to share with you. The IRS will punish you severely if you refuse to be organized in your business endeavors. The list of no-longer-rich people who have learned this lesson the hard way is long and distinguished.
Look at it this way, you need many skills to be a successful real estate investor, from finding the best deals and structuring transactions so that all parties benefit to executing exit strategies for maximum profit–just to name a few. In addition to those fun and exciting skills, you need to be organized in your accounting and bookkeeping. It’s just part and parcel of being an investor, entrepreneur, and small business owner.
Every expense and every item of income in your real estate business must be organized into a system that is easily accessible. Most small business owners use Quickbooks because it is the standard digital format for the accounting world. When your business books are correctly organized in Quickbooks, you have incredible control over your operation’s accounting.
Help – Bookkeeping Scares Me
If you don’t want to learn how to use Quickbooks yourself, hire a bookkeeper. There are thousands of bookkeeping services out there and many charge a nominal monthly fee to add you to their client list.
In addition to converting that shoebox full of receipts into a digital Quickbooks format, you should also organize how you are receiving income and paying bills in your real estate business. Every deposit and every bill should be transacted through bank accounts and credit cards specifically designated for the business.
Although this may sound time consuming to set up in the beginning, (especially if you have a bad habit of running business transactions through personal accounts) this will save you considerable time in the long run.
Bank accounts with companies like Bank of America and certain credit cards allow integration, so all transactions can automatically be imported into Quickbooks. It’s a huge shortcut to keeping your books organized and up-to-date, especially if you do the books yourself. Even if you hire a bookkeeper, he’ll greatly appreciate the automation as well.
Once everything is organized in Quickbooks, allow your CPA to unleash his/her skills to best structure your tax returns for maximum tax savings. They can re-classify transactions and adjust the way things are organized. In essence, you allow your CPA to do his/her job at a whole new level.
You’ll See Where Your Real Profits Come From
And perhaps the greatest benefit of being organized is being able to view your financial results with reports. Quickbooks has great reporting capabilities. It was extremely illuminating for me when I began to see where my real profits came from in my real estate investing business. It’s not always where you think. But the numbers don’t lie.
After my first time doing this so many years ago, I discovered that it almost never paid to do full rehabs. For 9 out of 10 deals, I was better off flipping full rehab deals to a specific type of investor/buyer (the kind who pay all cash and is also a contractor, so his renovation costs were low). I also discovered the power of wholesaling to retail buyers. These huge financial distinctions came from facts and results from the real world.
When you get your accounting and your books organized, you gain clarity in your business and give yourself the opportunity to save a tremendous amount in taxes.
# 4. Own Rental Property
Rental property is one of the greatest ways to earn money in the United States. Income from rental property is incredibly tax advantaged. When you buy a $100,000 rental home, you get to depreciate the structure of the property (not the land) over 27.5 years. Let’s say the lot is worth $10,000, that means the structure (and your tax basis) is $90,000. Each year, you get a tax deduction of $3,272.73 ($90,000 divided by 27.5 years).
So after all expenses, including maintenance, if your cash flow on that rental home is $270 per month, depreciation offsets that cash flow completely and you may not have to pay any taxes on that income! It’s incredible. Plus, as the property increases in value, you’re not paying any tax on the appreciation so long as you continue to own it.
# 5. Earn Income Like the Wealthy
You’ve probably heard politicians talk about how the wealthy pay so little in taxes. Technically, the wealthiest people in this country pay a very large total sum in taxes but, on a percentage basis, it is far less than the middle class. Why?
Because the wealthy earn some (or all) of their income through investments as opposed to working for other people. Rental property is one such investment that allows the wealthy to earn great money but not incur a heavy tax liability. Another example is when you sell your rental property after more than one year of ownership. That may incur a long-term capital gains tax (15%…soon to be 20%) as opposed to ordinary income tax (15% – 35%+).
An example of how this can work is if you buy a property, fix it up, and sell it on a 13 month rent-to-own, so that the tenant buys the property in little over one year. The net profit can then potentially be considered a long-term capital gain. Not only is your tax liability potentially much less, but you also can usually sell a property on a rent-to-own for top dollar and you typically have no real estate commissions. That’s a winning combination!
Another creative way to reduce your tax liability by earning income like the wealthy is with a 1031 exchange. When you sell that rental property, your profits may not be taxed at all if you do a 1031 exchange and move all that money into a new property purchase. In simple terms, this is the real world example of what you do in the game of Monopoly when you exchange 4 green houses for 1 red hotel.
How can the wealthiest people in this country pay the least percentage-wise in taxes? They earn their income from investments as opposed to jobs. Shouldn’t you be earning more of your income from investments too?