When it comes to taxes, many rental property owners fall into one of two camps. The first is afraid to deduct anything because of a mythical future IRS audit. The second deducts anything and everything and seeks out a CPA or tax preparer who will file on their behalf without doing much due diligence.
The most successful investors fall in between these two camps. They deduct everything that is legally allowable but nothing that is borderline or outright not a deductible expense.
The IRS has plenty of allowable deductions, so savvy real estate investors should be able to minimize taxes without going overboard. Here are three deductions you may not know about that can cut your taxes this year.
Those who deduct aggressively may try to fund an entire vacation by checking out a few houses while they’re in the area. Unfortunately, that isn’t allowable. That said, here are a few ways to deduct at least part of your vacation expenses.
The first is by having long-range rentals. Let’s say you live in Nevada and own a multifamily building in Michigan. As long as you travel to Michigan principally to visit your rental property, you can write off the expenses.
Theoretically, if you’re a retiree with children living in multiple states, you could purchase a rental property near each of them and fund trips to visit with the tax deduction for visiting these rentals. Of course, this doesn’t mean you can buy a rental property in Orlando and go to Disney World for two weeks every year — you have to be able to prove that the trip was for a business purpose.
The key here is to schedule business appointments ahead of time. Schedule an inspection of the property one day and a meeting with your property manager a different day.
CPAs like to call this second strategy sandwiching a weekend. If you travel on Wednesday, do an inspection on a Thursday, meet with your CPA on a Friday, and meet with a property manager on Monday, and then travel again on Tuesday, you can write off all travel expenses for Wednesday through Tuesday.
Travel days are considered business days, so in this example, you had five business days and a weekend sandwiched between them. You can do anything you want on the weekend, as long as the majority of your days traveling are spent on business.
2. Hire your kids
I don’t have a lot of stats on this, but I would guess that a lot of the types who own and manage rental properties got the entrepreneurial itch at a young age. For me that meant mowing lawns, edging, and tagging along on my parents’ business trips to help where I could. Hiring your kids is a way to help introduce that entrepreneurial spirit while also writing off their allowance.
The IRS has no child labor rules, so as long as the work your kids do is considered normal for their age and their pay is considered normal, you can hire them. That means while you could hire your 12-year-old to mow rental lawns for $12 an hour, you probably shouldn’t be hiring your 6-year-old to fix roofs for $5,000 a day.
The first step for this is to set up your legal entity to do payroll and put your kids on it. You can then pay them for help cleaning up, doing yard work, and even helping with office tasks as they get older. As long as you issue them a W-2 at the end of the year, any allowance you pay them for rental property work is deductible.
There’s a common investor saying that compound interest is the eighth wonder of the world. Real estate investors will tell you that depreciation is the ninth. Depreciation is a noncash expense that is deducted from rental property income each year. It is a way the IRS allows investors to recapture the cost of the buying the property over time.
Because depreciation is noncash, it’s possible to own a property that is cash flow positive but net income negative. That means you make money on the property but don’t owe any taxes.
Depreciation is no secret, and I’m sure you know about it and are already taking the deduction, but it’s worth taking the time to make sure. When you sell a property, the IRS will assume you took depreciation. It makes no sense, and isn’t allowable, to decide not to take depreciation in certain years. If you find a year when you didn’t (or your tax preparer didn’t), find a new CPA and restate that year.
The bonus here is, ahem, bonus depreciation and cost segregation. Many rental investors will segregate their property between land and building and stop there. The land can’t be depreciated, and the building is depreciated over either 27.5 years (if it is a residential building) or 39 years (if it is a commercial building).
You can get a lot more bang for your buck if you segregate more than that. Parts of the property that are “dedicated, decorative, or removable” can be depreciated far faster. This includes everything from carpets to decorations to furniture and finishes.
Let’s say you buy a commercial building for $750,000 and the land is worth $100,000. Normally, you’d depreciate the building over 39 years and have annual depreciation expense of $16,667 ($650,000 / 39). If you commission a cost segregation study and find that $100,000 of the building can be considered personal property that has a five-year useful life, you can increase your depreciation expense to $34,103 ($550,000 / 39 + $100,000 / 5). If your marginal tax rate is 24%, you save more than $4,000 on taxes (($34,103-$16,667) * 24%).
Even better, until 2023, you may be able to use bonus depreciation and write off the entire value of the personal property. That means in year one, your depreciation expense could go from $16,667 to $114,103.
The catch is capital gains taxes. When you sell the property, the IRS will reclaim the taxes on that depreciation at a 25% rate. The loophole around that is to use a 1031 exchange to exchange the property for another one when you’re ready to sell. As an accounting professor I had in college always said, “Defer, defer, defer … die.”
Creative accountants and business owners have found hundreds of ways over the years to reduce taxes with allowance deductions. Here, we’ve shown you how to fund a vacation with deductible expenses, write off your child’s allowance, and potentially increase your depreciation expense by five times.
There’s no need to use aggressive accounting when you can use the IRS’s own rules to reduce your taxes. Just keep track of all your expenses and have business-related reasons ready for each of them.