Whether you are investing in your first duplex, or own a large portfolio of small multifamily properties, you should always have tax plan in place. One of the biggest payoffs to owning real estate are the tax benefits that come with rental property ownership. Most new investors, and many experienced ones as well, don’t fully understand all of the tax benefits that come with rental real estate.
In this guide, I outline 5 tips that duplex investors need to understand when it comes to tax reporting. For simplicity, this guide is written specifically for duplex investors. The concepts that follow are easily translated to other property types. Investors who own triplexes and quadplexes will simply divide their expenses by 3 or 4 respectively, depending on their property type.
Without further ado, here are 5 tax and accounting tips for duplex investors.
1. Owner-Occupied or Fully Rented?
Before anything else, it’s important to categorize your duplex as either owner-occupied or fully rented. It may seem obvious to you, but the answer will determine how you should keep your books.
If you rent out both sides of your duplex, you should account for all your rental income and expense in the same set of books. These numbers will be reported on Schedule E of your 1040.
If you owner-occupy your duplex, you should make every attempt keep your personal expenses separate from rental expenses. Deductible expenses related to your home are reported on Schedule A and subject to standard deduction limitations. Rental expenses are reported on Schedule E.
Open a business checking account and run all your rental activity through that account. Doing so will make your bookkeeping a breeze, and tax time much less stressful.
2. Reduce your cost of living expenses
Duplex investors that owner occupy have far more cost reduction strategies than a typical homeowner. Mortgage interest, property taxes and insurance premiums are all costs that should be split between personal and rental expense.
Personal expenses can only be itemized on Schedule A, and are subject to limitations of the standard deduction. However, rental expenses are reported on Schedule E, and are not subject to the same limitations as personal expenses. This is why it’s important to distinguish rental from personal expense.
Shared expenses between you and your tenant can include Utilities (water/sewer/gas/electric), Internet, Landscaping, Trash and Snow Removal. Billing back your tenant for their share of these expenses is a great way to reduce your own cost of living expense.
Unfortunately, most tenants prefer to pay one rent amount, and may balk at the idea of getting billed back for every expense. So how do you account for those expenses that can’t be billed back? An easy way is to have your rental checking account reimburse you personally for all shared expenses. This way you are increasing your personal cash flow, as well as insuring you get a deduction on Schedule E for your rental expenses.
3. Depreciation and Cost Segregation
Depreciation is arguably your most important expense as a real estate investor. It is the primary reason why you pay no tax on your cash flowing rentals.
When rental properties are purchased, they are accounted for as capitalized assets on the balance sheet. The depreciation deduction you take against this asset represents the “used up” (expensed) portion of your rental property over the past year.
Residential rental property is depreciated over 27.5 years. To calculate your depreciation deduction, first split the purchase price between Land and Building (ie 20/80). If you owner-occupy a duplex, you can only depreciate the rental side of the property. Divide your building basis in half, and then divide that amount by 27.5. The result is your yearly depreciation deduction.
For example: You paid 500,000 for a duplex that you owner occupy. You allocate 100,000 to land and 400,000 to the building. Divide 400,000 in half to obtain your depreciable basis of 200,000. Divide that by 27.5 to arrive at your yearly depreciation deduction of $7,272.
What this means is that if your operating income (Rent minus all your rental expense: mortgage interest, insurance, taxes, repairs, utilities, etc.) is less than your depreciation, then you pay no tax. That’s an oversimplification, but generally correct.
Cost Segregation studies are advanced tax strategies that produce bigger depreciation deductions. This strategy is common in commercial real estate, but less so for residential investors. However, cost segregation studies do make sense for some residential property (ie – highly profitable short term rentals). Another strategy is to couple cost segregation with real estate professional status. This would permit large passive losses to be deducted against ordinary income!
4. Reduce your taxable income
Because of depreciation, it is common for rental property to be cash flow positive, but generate losses on paper. Net income/loss from rental property is classified as “passive” by the IRS. Passive losses can only be applied to passive gains, and generally cannot be applied against ordinary or portfolio income. However, there are 2 exceptions to this rule: the 25k Offset, and Real Estate Professional Status
Investors with less than 100k of modified adjusted gross income (MAGI) may be able to deduct up to 25k of passive losses against ordinary income. To qualify for this exception, the investor must meet 3 requirements:
- Active participation – easily proved if self-managed, if using property management you will need to prove decision making authority over the PM
- Income limitation – completely phases out at 150K MAGI
- Must own at least 10% of the property
Real Estate Professional Status
If you are full time in real estate, you may be able to qualify for real estate professional status (REPS). Doing so would allow you classify your passive losses as non-passive. This would allow an investor to apply rental losses against active income.
There are 2 main requirements to achieving this status:
- More than half of your working hours must be spent in a real estate business.
- You must work at least 750 hours in a real estate trade or business
An example of real estate professional might be a realtor, property manager, or apartment syndicator. If you have a full time job outside of real estate, then the first requirement disqualifies you for REPS.
This is an advanced tax strategy with strict requirements. REPS is a red flag for the IRS and increases your chance of audit dramatically. If the IRS ever comes knocking, documentation of time spent in your real estate business is critical to proving your case.
5. What happens when you sell?
When rental property is sold, it is subject to capital gains taxes. If the property is owned for less than a year, it will be subject to short term capital gains at a higher rate. Most investors plan to hold their rentals for the long term. But there are instances when you may need to sell a rental property earlier than intended. If you are faced with this decision, considering holding it for at least a year, as that will open up many more tax strategies that wouldn’t be available selling it short term.
You also have to pay depreciation recapture, which is a 25% tax on all depreciation. Please note, you will be responsible for depreciation recapture whether you deducted it or not.
When you sell your primary residence, you may be eligible for the Home Sale Gain Exclusion. What this means is you can exclude up to 250k (Single) or 500K (MFJ) in gains on the sale of your home. To be eligible, you must have lived in your residence for 2 out of the last 5 years.
Because the IRS treats the owner-occupied side of your duplex differently from rented the side, it is important to track your basis in each separately. This is another example of how keeping separate books for your rentals will make your life so much easier when it comes time to sell.
This article is intended for informational purposes only. Anything presented here should not be considered tax or legal advice. Please consult with your CPA and attorney for tax and legal advice.