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December 18, 2023 | read

Top Ten Tax Mistakes Real Estate Investors Make

Brandon Hall

The tax code is so darn complicated that mistakes are bound to happen. In most cases, folks who are using big box software brands to self-prepare their tax returns feel that the software adequately meets their needs. But boy do things change once one enters the world of alternative asset investing, especially when it comes to real estate.

Regardless of whether you’re a DIY or “hire the pro” type of landlord, here are the top ten real estate tax mistakes that I see investors make time and time again without fail. These tax tips for real estate investors will help you review your own tax returns to prevent future mistakes.

1. Not accounting for depreciation

You’d think that most people would know depreciation is a must when reporting their rental property on their tax returns. After all, depreciation is one of the top tax benefits that come from owning rental property.
Depreciation is an annual deduction that you receive for purchasing a rental property meant to track the deterioration of your property over time.

Depreciation is often called a “phantom expense,” because you don’t have to spend any additional money after purchasing the property in order to receive the annual write off. Think of it as a small annual credit that the IRS provides you each year as a thank you for investing in our economy. Despite this, many people miss depreciation on their tax returns. Our firm has helped investors recover decades worth of missed depreciation.

Not sure where depreciation shows up on your tax return? Check out Schedule E, Line 18. If you have rental properties and Line 18 is blank or $0, something is wrong.

2. Not allocating value to land

One of the most frequent tax mistakes I see is incorrectly depreciating your rental property by inadequately allocating the value of the land.

What do I mean by allocating a value to land? When you purchase a rental property, you are purchasing the building, the building’s contents, and the land that the building sits on. Thus, we must allocate the purchase price of the property between the building and the land.

To do this, the property tax card must be pulled from the tax assessor’s database. This is relatively easy – just type into Google “[your county] real estate assessor” and that should take you right to the page we need. You’ll then want to search for your rental property’s address and pull the property tax card to provide the assessed value of land and improvements.

This ratio will help you calculate how much of the purchase price needs to be allocated to the land:

For example, if the property tax card claims your land is worth $10,000 and the improvements are worth $90,000, then if we bought this property for $400,000, we’d allocate $40,000 to land (10% of $400,000) and $360,000 to the building (90% of $400,000).

The kicker is that land cannot be depreciated, only the building value can be depreciated.

3. Deducting monthly escrow payments

Your monthly mortgage payments are broken up between interest, principal, insurance, and property taxes. Don’t make the mistake of deducting the escrow portion (the insurance and property taxes) each month as you pay your mortgage bill.

Think of escrow like a separate bank account that stores your assets and makes them harder to get to. The money in escrow is still your money, the bank is just forcing you to set it aside for future payments of insurance and property taxes.

4. Thinking that you need an LLC to deduct business expenses

A business expense is a business expense regardless of whether you have an entity set up. Don’t make the mistake thinking that an entity will make your business any more legit than it would be otherwise. Sure, you get to use the cool “LLC” acronym but you won’t have access to previously untapped business deductions.

5. Thinking that all travel costs are deductible

Travel costs come in various shapes and sizes and not all are deductible. What I often see misreported are travel costs to explore a new area to invest. It’s extremely important to understand that these exploration and expansion costs are not deductible until you purchase a property within that same geographic area.

Seems unfair right? Not really. Though I rarely side with the IRS on any issue, I’m on their team here. If this rule wasn’t in place, everyone would write off their annual vacations that require travel costs to get to the destination. “Yes my annual trip to Hawaii for the past ten years was deducted on my returns because I was exploring the feasibility of buying a rental property there.” “No officer, I did not buy a property, but I intend to at some point.”

See my point? The IRS knew that loophole would be exploited so they were quick to close it.

6. Not using a home office

We encourage our clients to take advantage of the home office deduction, not so much for the deduction itself, but more so for what it unlocks. It does not have to be an entire room, just a portion of the room that is used exclusively and regularly for your real estate operations. Without a home office, your transportation costs to and from your home and place of business are not deductible. The IRS deems these transportation costs a personal commute. But when you add in a home office, all of a sudden you are transporting from place of business to place of business, thus it’s a business trip.

7. Not advertising the property for rent the day you close

This is a critical mistake new investors make. If you do not advertise your property for rent, you have failed to place the property into service. So what’s the big deal?

Any cost incurred prior to placing the property into service is a capital expense. This means that it is added to the basis of the property and depreciated over a span of 27.5 years. This is bad for two reasons: (1) we lose flexibility to deduct the costs in the current year if applicable; and (2) we’d rather deduct the costs in the current year than depreciate (we gain the benefit of the write off this year rather than over 27.5 years).

If instead you advertise the property for rent the day you close, we won’t need to capitalize every expense. Instead we’ll have the flexibility needed to determine if the expense is a repair or maintenance item rather than being forced to capitalize the expense.

A good example is painting. Painting is considered a maintenance expense and currently deductible. But if you paint prior to advertising the property for rent, it’s a capital expense depreciated over 27.5 years!

8. Using a 529 plan for your kids

As a real estate investor, you have access to many savings options that are much better than a 529 plan, which is a tax-advantaged savings plan used to encourage saving for future education costs. With a 529, you could only receive a deduction at the state level (sometimes none at all) and you’ll end up out of luck if your child ends up being brilliant and earning scholarships.

Other options exist; I urge you to connect with a CPA and financial planner to explore such options.

9. Running an ineffective document management system

Without document management and retention, we can’t craft tax strategies because there is no baseline or proof. I always urge new investor clients to set up a document management solution prior to implementing our sexy tax strategies.

It doesn’t have to be fancy. My suggestion: Go virtual so that you can do everything on your smart phone. Get a cloud based storage system and use Expensify or your CPA’s client portal app to upload documents, receipts, and invoices. Your CPA doesn’t have an app for their client portal? Get a new CPA!

We use ShareFile and our clients love it. The smartphone app allows the client easy access to our secure client portal.

10. Not using a 1031

A 1031 exchange allows the investor to defer capital gain on the property they are selling by rolling over the profits into the next investment property. Don’t leave money on the table and forget that this great tool exists.

I’m always amused Landlord’s notoriously do-it-yourself mentality. I know not only from working with hundreds of landlords, but also because I am one myself. For example, our dryer broke the other week. With the help of YouTube and Amazon, I had the dryer up and running next day for only $20! But you’d never catch me setting up my own entities to hold my real estate investments. There are too many traps and pitfalls, and I’m not a legal expert. You should approach your tax situation the same way.

Whether you’re new to the investing game or you’re an old pro, it is always important to have a team behind you to ensure that you are making the smartest, and most advantageous business decisions. If you have questions about any of the real estate tax mistakes and strategies I’ve discussed above or are interested in exploring our solutions, drop me a line to schedule your consultation today.