Tax Planning for Real Estate Professionals: Classification, Cash Basis and More!
Originally published on June 1, 2021
Updated on August 16th, 2022
We’ve found that many real estate professionals don’t have a plan for taxes—despite how widely they impact their business. In the second video of our two-parter on tax planning for real estate professionals, JMCo partner John VanDuzer and director Kevin Golden discuss the real estate professional classification, setting up a retirement plan, the cash basis method of accounting, and the business interest limitation.
The Real Estate Professional Classification
Our previous video discussed how depreciation affects your tax picture, and that’s where VanDuzer began this session. “The benefit of depreciation is we have the potential to create a lot of losses,” he said. “But what happens to those losses when they flow down to the individual level? And are you able to get benefit for those losses?”
Real estate is generally a passive activity. This means the professional isn’t “materially involved” in running the business. The resulting income is considered passive activity income.
“If someone is passive in an activity, then by default they cannot take those losses until they have passive income to offset them,” said Golden, “or, they get rid of that property.”
This rule was designed to stop people who do real estate on the side from sheltering income from active or investments sources. Unfortunately, it results in a longer wait to get deductions. However, for individuals whose primary focus is real estate, Congress came up with the “real estate professional” classification. To qualify as a real estate professional you must:
- Spend more than half of your time in a real property trade or business, and
- Spend at least 750 hours per year in a real property trade or business.
If you qualify as a real estate professional in the eyes of the IRS, you have the opportunity for your rental income and losses to be classified as non-passive, provided you meet material participation criteria. “So now, if I’ve got some properties that maybe have losses because of those favorable depreciation laws, I don’t have to wait for those properties to turn a profit to take those losses,” Golden said. “I can offset those against maybe my other income.”
This classification also means you’re not subject to the net investment income tax. Brought about by the Affordable Care Act, this 3.8% surtax on investment income applies above a certain income threshold.
If you’re married and file a joint return, only one spouse has to qualify as a real estate professional. This means any real estate investments you own that fit the material participation standard are eligible for this favorable treatment.
Qualified retirement plans allow you to both have a tax deduction and keep your money. The IRS allows taxpayers to deduct retirement account contributions from their returns. To contribute to a qualified retirement account, you must have earned income.
However, rental income is not considered earned income. This creates issues for real estate professionals who want to save for retirement and enjoy the tax benefits.
To circumvent the issue, you can set up a management company to manage your real estate portfolio. The company then “pays” appropriate management fees to the management company. Making this adjustment will have little if any affect on your operations while creating earned income for you.
VanDuzer explains that, while such a setup makes sense once your business hits a certain size, make sure your arrangement reflects real-world conditions. “You can’t charge 75% management fees; it has to be reasonable, market rate management fees,” he said. “But it does give you some leeway to take advantage of things that may not be available otherwise”
Cash Basis Accounting
While there are benefits to both the cash basis and accrual accounting methods, the former brings tax advantages for real estate professionals.
Cash basis accounting records transactions when payment (e.g., rental income, cash paid for a property sale) is actually received. This allows a measure of control over your yearly income and your expenditures to avoid a higher tax bracket. You can time property maintenance projects to fall in whichever fiscal year you’d like to take the corresponding deduction.
“If in the next six months, you’re going to do an entire repaint of the property, and somewhere in the middle of there your year-end falls, you have a decision. ‘Do I take the deduction this year, or do I take the deduction next year?’” said VanDuzer. “With some careful planning, really lay out the amount of taxes or income you want to get to, and manage that through your expenses on cash basis.”
The Business Interest Limitation
The Tax Cust and Jobs Act (TCJA) brought about new limits to deducting business interest expenses. Per section 163(j) of the tax code, “The amount of deductible business interest expense in a taxable year cannot exceed the sum of the partnership’s business interest income, 30% of the partnership’s ATI, and the partnership’s floor plan financing interest expense.”
An exception was made for small businesses with less than $26 million in average gross receipts. However, if your real estate enterprise is considered a tax shelter, it’s not entitled to that exception.
“One of the definitions of a tax shelter is a syndicate,” VanDuzer explained. “A syndicate means more than 33% of losses are allocated to a limited partner or a limited entrepreneur.” Let’s use an example:
- Kevin and John are partners in a real estate enterprise. Both are 100% active in the property.
- They also have two silent partners who have invested capital but have no participation in operations.
- If the entity has any losses, 50% of those losses will be allocated to the silent partners—making Kevin and John’s entity a syndicate.
In another instance of special rules for real estate professionals, you can elect out of these rules if you change the depreciation method on your assets. “Instead of being under what’s called MACRS, which is the standard accelerated depreciation for tax purposes, you have to be under ADS, which is an alternative depreciation,” said VanDuzer. This move, however, also means you can’t get bonus depreciation for qualified improvement property.
VanDuzer and Golden recommend a careful evaluation on whether it’s better to be subject to the business interest limitation or to slow down depreciation. Working with a real estate CPA on this and other operational matters can help clarify your tax picture and save you money on your return.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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