It’s tax time again, which means that most people are gathering their documentation and counting their deductions. However, many people, homeowners, and investment property owners especially, don’t realize that they could be saving much more money than they are currently. Property owners are afforded all sorts of tax breaks and incentives that can sometimes be overlooked by those who are not 'in the know.' In many cases, employing the help of a CPA rather than doing your taxes yourself can garner a much larger tax return. We caught up with Brandon Hall from The Real Estate CPA to learn a little bit more about homeowner tax advantages, investor tax incentives, and why employing a CPA is a smart move.
Now, you might be wondering, why are there tax incentives for property owners anyway?
Back in the day, Congress decided it would be a good idea for US citizens to own homes. The best way to encourage citizens to do anything is through tax modifications. So, Congress decided to incentivize home purchases by re-writing the tax code to allow for deductions related to you your property. The most well-known of which are the mortgage interest deduction and real estate property taxes.
"The main tax breaks homeowners benefit from are the real estate property tax deduction and the mortgage interest deduction,” says Hall. “However, proposals in congress are currently set to eliminate certain itemized deductions. These deductions are advantageous because they reduce the cost burden of owning a home. If we get rid of these deductions, we may see a decline in home ownership.” If you’d like to delve deeper into the possibility and effect of the proposal, Forbes has an informative article you can read.
Currently, homeowners are allowed a deduction equal to the interest paid on their residential mortgages, meaning taxpayers save an amount equal to the mortgage interest paid multiplied by their marginal tax rate. This means a taxpayer in the 25 percent bracket who paid $10,000 in mortgage interest would save $2,500 in taxes. “Homeowners can also deduct Private Mortgage Insurance (PMI) though there are certain rules regarding how much you can deduct and the timing of the deduction,” continues Hall. “Homeowners can also qualify for a tax credit for qualified energy properties. So, if you were to put solar panels on your roof, you can receive a tax credit for 30% of the cost. However, this credit will be phasing out and eliminated over the next few years.”
While the energy credit is always a stretch, if you can benefit from it (i.e. improving your home with energy savers will substantially raise your home value) then you should jump on this.
For clarification, you would receive a tax credit, not a tax deduction. “A tax credit is much different than a tax deduction,” advises Hall. “For example, a $10,000 tax credit directly offsets your tax bill by $10,000. By contrast, a $10,000 tax deduction reduces your tax bill only slightly. To calculate how a tax deduction affects your overall tax position, you multiply the deduction by your marginal tax rate. So, if you are in the 25% marginal tax bracket, and you have a $10,000 tax deduction, you will save $2,500 in taxes. As you can see, a tax credit is much more powerful.”
Homeowners aren’t the only ones who get massive tax incentives, investment property owners enjoy huge savings as well. “Investors enjoy many more tax advantages than homeowners who live in their homes. For instance, rental property owners can deduct homeowners insurance costs, legal fees, accounting fees, advertising, utilities, repairs and maintenance, landscaping, travel, transportation, meals and entertainment, office supplies and equipment, education costs, subscriptions, and cell phone expenses,” continues Hall. “Essentially, a rental property owner is seen as owning a business and enjoys many of the same deductions that business owners are allowed to take.”
Another lesser known investment tax credit: Rental property owners can improve property located in historic zones and receive a 20% tax CREDIT for the cost of the rehab. “Several of our clients have built an entire development business based around this model,” says Hall. “It allows investors to invest in a property at a much lower cost basis compared to a home in which the tax credit was not available.”
“For example, if you buy a $100,000 home in a historic district and put $200,000 into the home for a rehab, your cost basis will be $260,000 after you take the 20% tax credit on the rehab costs into account. Compare that to the same home that's not in a historic district, your cost basis will be $300,000. Why does cost basis matter? It affects your return on investment. If these two properties each cash flow $20,000 per year, the property with a cost basis of $260,000 has an ROI of 7.7% whereas the property with the $300,000 cost basis has an ROI of 6.7%.” This may not seem like a huge difference, but spread out over 20 years, the 1% higher ROI results in much more wealth.
Another big credit that investors can take advantage of is depreciation. Essentially, depreciation allows you to "track" the deterioration of your property. “When you purchase a property, you cannot write-off the purchase price (a common misconception). Instead, you slowly write-off the purchase price over 27.5 years (39 years for commercial property). So, if I spend $100,000 on a property, $10,000 may be considered land, which cannot be depreciated. However, the remaining $90,000 can be depreciated over 27.5 years. Every year, my depreciation is $3,273 until I either sell the asset or completely write it off. This $3,273 depreciation expense reduces my taxable income, but I don't have to continue paying 'out-of-pocket' for it as I already paid for the asset up front." For example, if a property's net operating income is $4,000 during the year and my depreciation is $3,273, the owner gets to keep the full $4,000, but only has to report $728 as taxable income, because of the depreciation offset. This is called a ‘phantom’ expense because it doesn't require them to continue paying for it.
If this all sounds a bit complicated to you, that’s because it is. If you own a primary residence and don’t have any investment property you can usually get away with using a big-box software program or tax service. However, if you have an investment property, you should probably bite the bullet and hire a CPA who KNOWS real estate. “While I truly feel all CPAs are brilliant, they definitely do not all know the intricacies of real estate taxation,” warns Hall. “The worst mistakes I've seen with a new client's prior year tax returns have been prepared by CPAs. Be very careful.”
A knowledgeable CPA can ensure you are maximizing your tax position, whereas big box software or stores will not.
At The Real Estate CPA, they advise their clients to meet with them outside of tax season so that they can assess your entity structure, pick a retirement strategy that works for their clients, set up a repair/maintenance strategy, and give ongoing advice. “Please do not kid yourself and think that you can do this yourself. It's complicated stuff. You could end up like one of my clients who came to me and we found out she hadn't been depreciating her property for 20 years. 20 years!” Talk about a lost opportunity!
Of course, a CPA can help during tax time too, resulting in massive savings, just be sure to pick one that is well versed in real estate tax law. Over the years, these and other lesser known tax breaks for homeowners and investors can add up to thousands that can be used for repairs, down payments on more property, or simply a well-deserved vacation!