Buying investment property might be one of the smartest moves you make while planning for your financial future. Passive income from a rental property can possibly lead to a big profit when you eventually sell. It may also be part of your strategy to build generational wealth, with a plan to pass that property down to your children or grandchildren someday.
But while real estate investors are great at looking far down the road, they sometimes overlook the more immediate tax considerations that are involved with buying investment property and renting it out. These are just a few of the common mistakes real estate investors make around tax planning.
Keeping Sloppy or Incomplete Records
Real estate investors can’t afford to be disorganized with record keeping. If you’re missing things like receipts for travel expenses and documentation of rental income, it’s going to be challenging to complete your tax return. You don’t want to deduct expenses that you can’t back up with documentation if the IRS audits you. You also don’t want to waste time scrambling for crumpled receipts when you’re meeting with your tax planner. And, maintaining complete and accurate records makes it possible for you and your advisors to assess how much of a return (or loss) your investment is really providing.
So make sure you have a system for organizing all records related to your investment property. Using software designed for rental property owners makes it fairly straightforward to upload documents and track records (always keep paper documents as backups).
Mishandling Repairs and Improvements
To non-real estate investors, the difference between a repair and an improvement might not seem like a big deal. But it’s a big deal to the IRS, which means it has to be a big deal to anyone who’s buying investment property. Repairs are activities that keep the investment property in good condition; things like fixing broken fixtures and repainting are repairs. Improvements are things that add value to the property, like upgrading the appliances or installing a new security system. The distinction matters because repairs can be deducted in the year that they’re made. Improvements can’t be deducted. These costs can only be recovered through depreciation.
Reporting repairs and improvements can be tricky for real estate investors because the line between these categories can be blurry. For example, what if a floor in your rental property is damaged? Replacing part of the floor would generally be considered a repair for tax reporting purposes, so you could deduct the cost in your next tax return. Replacing the entire floor would be an improvement and you would only be able to deduct a small portion of that expense on your tax return every year over the course of many years.
Leaving Deductions on the Table
Buying investment property opens you to a ton of possible tax deductions, and not taking advantage is an expensive mistake. Your tax planner can help you identify deductions for which you’re eligible. Some of the key deductions you may want to take include:
- Certain travel expenses. Location always matters when you’re buying investment property. For tax planning purposes, the proximity of your investment properties to your home may affect your tax deductions. If you buy a rental property in a vacation town several hours away from home, you can’t deduct the cost of traveling to and from the home for your own use. But you can deduct travel expenses that you incur from collecting rent or making repairs to the property.
- Home office deduction. Even if you don’t typically work from home, you might be eligible to take a home office deduction for your investment property operations. Your home office doesn’t have to be a full office, just some portion of space in your home that’s dedicated to running the business. Taking a home office deduction also allows you to deduct a portion of your utilities, mortgage interest and other household expenses.
- Professional fees. Attorneys fees and other professional fees that you incur for your investment property business may be deductible.
- Cleaning and maintenance. If you pay someone to clean, mow the grass and do other maintenance work for your investment property, you may be able to deduct those expenses.
Misreporting Rental Income
Many new real estate investors misreport rental income unintentionally. All rental income must be reported on Schedule E. If a tenant pays advance rent that covers a future year, the full amount must be reported as income in the year it’s received. Security deposits are considered advance rent. If you accept property or services in place of some or all of a tenant’s rent, the fair market value of those services must be reported as rental income. For example, you might agree to let a tenant live in your property for half the fair market rent in exchange for them doing some cleaning and maintenance around the property. You still must report the full rent amount in your income.
Your Tax Planner Can Help You Avoid Mistakes
There are a ton of variables at play when real estate investors approach tax planning. If you buy a second home in your neighborhood to rent out, your tax situation will probably be simpler than that of someone who’s buying investment property in multiple states and flipping it. So your tax planner is the best source for guidance about the tax opportunities and challenges in your specific situation. Learning how to maximize deductions and minimize IRS attention now can make tax season easier in future years.
The tax advisors at Sachetta, LLC work with real estate investors all the time. We’ve seen the tax mistakes that new investors tend to make, so we can help you navigate around them to make tax planning and tax preparation as easy and audit-proof as possible. If you’re thinking about buying investment property, or already own rental property, contact us today.
Emily Diezemann, MBA is a Staff Accountant with Sachetta primarily working with business clients as part of the Tax & Accounting team. She has been with the firm since she began as an intern in 2016. Emily holds an undergraduate Accounting degree and a MBA from Endicott College. She lives in Peabody, MA and enjoys hanging out with friends and traveling.