Mortgage + insurance + taxes. If, like a lot of landlords, you’ve set up escrow, these charges come out of your account every month. You probably don’t think much about them and as a result, they can feel immutable. But trust us, they’re not, and finding ways to lower any of the three can have a huge impact on your monthly expenses as a real estate investor.
In particular, landlord’s and real estate investors often ignore the control they can exercise over financing expenses. From the taxes you pay to the government to the interest you pay to the bank, you can lower financing expenses from your properties.
Take Advantage of All Tax Breaks
With the exception of a small percentage of masochistic accountants who exhibit psychopathic tendencies, people rarely look forward to doing their taxes. Even if you set aside an appropriate amount to hand over to Uncle Sam come April, watching your bank account drain down with nothing tangible to show for it is never fun. But for savvy real estate investors who understand the power of depreciation and other tax advantages, tax season can be fun. Many property owners are able to lower their personal tax bill by so much that they get money back from the IRS, and what’s more fun than that?
We could write a whole book on taxes for real estate investors (plenty of people have), but we’ll keep the overview light here. Just know that, along with rental cash flow, amortization, and appreciation, tax advantages / savings are one of the big four wealth generators a rental property offers an investor. Because it’s so powerful, it’s worth trusting an expert. We strongly advise that you hire a CPA to handle your rental property related tax filing. That being said, you’ll maximize your savings if you’re in the know yourself. Here’s just some of the info you should become familiar with:
You’re a Business, Not an Investor
For tax purposes, the IRS will assign you one of three classifications determined by your behavior and motive. You’ll be considered either a:
- Business owner – you engage in the business regularly and continuously to earn a profit
- Real estate investor – you passively invest and are not heavily involved in regularly managing your real estate
- Property owner for not-for-profit activity – you repeatedly report no income to the IRS
As a business owner, you’ll have access to a number of tax deductions you would not otherwise have, including the Pass-Through Income Tax Deduction, Home Office Deduction, Net Investment Income Tax, and many more. Real estate investors enjoy far fewer tax advantages. Being classified as a not-for-profit is a disaster as you’ll lose nearly all real estate tax saving opportunities.
It is a tremendous advantage to be considered a business owner. You should work hard to ensure you’re classified as such (if you can). It’s not overly challenging to do; as long as you’re regularly involved in managing the properties or you pay a property manager to do the same, you should qualify. This is also why it’s so important to maintain accurate records in the case of an audit.
The All-Powerful Operating Expense
You’re likely familiar with depreciation, but to give you a brief definition, depreciation is a reduction in the value of an asset overtime. For tax purposes, depreciation allows you to lower the income you received from your property investment and, as a result, lower your tax bill (or in the best case, increase your tax return).
Depreciation is incredibly useful as an investor, but it is ultimately recaptured upon sale of the property. The profit you report to the IRS is not based on the original purchase amount, but instead on the purchase price minus any depreciation you’ve already taken.
Operating expenses, in contrast, are like depreciation that’s never recaptured. Operating expenses lower your tax bill with no negative repercussions. To qualify as an operating expense, an expense must be ordinary and necessary, current, directly related to your rental activity, and reasonable in amount. This typically includes repairs, maintenance, and other costs associated with running your business.
Talk to your CPA about how best to record charges. They’ll help ensure you’re maximizing operating expenses vs. depreciation. It can make a big difference on your tax bill both this year and when you’re ready to sell your property.
De Minimis Clause
The De Minimis Clause is one of the most useful tax deductions available. It allows you to currently deduct any items that cost $2,500 or less each, regardless of whether or not they are an improvement or repair. This allows you to quickly capture the depreciable value of an asset with no future consequence.
For example, normally, when you purchase a $2,000 washing machine, you depreciate it over 5 years. But with the de minimis clause, you instead take the full $2,000 as a single expense this year, lowering your tax bill without depreciating the value of your property.
Keep in mind, however: you cannot artificially break a purchase into multiple components to count each as less than $2,500. You couldn’t, for example, purchase a refrigerator for $2,500 and separate the door, tubing, shelves, etc. on your taxes so that each component is individually less than $2,500.
Again, your accountant should be able to help you navigate through this. Just be aware of it as you make purchases. You’ll be properly prepared to maximize your tax savings.
Other Tax Tips
A few other smaller items to keep in mind in preparation of tax season:
Consider the Home Office Exclusion – this is a tax deduction that allows you to deduct, as business expenses, the costs associated with working out of a home office. This deduction is only available if
- your rental activities qualify as a business (another reason to ensure that’s the case!)
- you use your home office exclusively for your rental business, and
- you use it on a regular basis.
The deduction includes any direct expenses related to the office. Think: furniture, paint, carpeting, etc. You can also deduct expenses that are related to the entire home, including rent paid, mortgage interest, property taxes, utilities, insurance, etc. You cannot, however, deduct these amounts in their entirety. Instead, you’re limited to the amount that relates to the office itself.
There are a number of different ways to determine how much you can deduct, but most commonly, you’ll divide the square footage of your home office by the square footage of the entire home. Multiply this factor by any expenses to get your home office deductible amount.
Track ALL Expenses – we mentioned the importance of good record keeping above, but it bears repeating: track all of your rental business related expenses. This includes any purchases you make, any miles you drive, or any other costs you can possibly record. This will prove useful for two very important reasons:
- In the hands of a good CPA, it will ensure you minimize your tax bill and maximize your rental property profit and…
- It will protect you in the case of an audit
We’re loath to bring up the dreaded audit here, but it is a real consequence of aggressive tax deducting. Protect yourself by maintaining excellent records.
Challenge Your Property Tax Assessment
If you aren’t making money on your properties, you likely won’t pay any additional tax on your income – you might even pay less. But that is not true of your property taxes; they are truly unavoidable.
Every state has property taxes, but the percentage depends on your municipality. Regardless, it’s money out of your pocket based on the value of your property. If you have a property that has been assessed at a low value in comparison to other nearby homes, you’ll enjoy a nice tax savings. If the value is higher than the norm, you’ll end up paying more.
We’re certainly not here to quibble with the first, fortunate scenario, but if you find yourself with an inordinately high property tax bill, you may have reason to dispute it.
The taxable value of your property is an assessed one, and as such, it is inherently subjective. It’s not derived using a precise mathematical formula or scientific method. Sure, the county assessor would like to be as consistent as possible, but each property is unique in one way or another. As a result, there is inescapable variance in the numbers assessors give. If you believe your assessed value is too large, here are the steps you should take:
- Act Fast – Most municipalities only allow you to challenge the assessed value of your property within 30 to 90 days of the assessment. What’s more, many don’t re-assess values every year, instead, doing so once every 3 to 4. When your property is assessed, be sure to read the assessment letter that you should receive, check to make sure the information they have about your property (like lot size, legal status, beds and baths, etc.) is correct, and respond right away if you want to dispute the number they’ve given.
- Check the Value of Other Similar Properties – Look up comps. As a real estate investor, you should be familiar with this, but rather than looking for the amount a property was sold for, you want to know its assessed tax value. This is likely available on the county assessor’s website. This will be the first piece of evidence to prove your assessment is out of line.
- Consider Hiring an Appraiser – Depending on your situation, it might be worth it to hire a professional. They’ll of course look at comps, but they have a much deeper well of knowledge to pull from and they’ll provide a bit more credibility to the tax office.
- Request a Review – Before formally submitting, call up your local assessor’s office. You’ll be surprised how far a friendly conversation can get you. Present your case verbally over the phone first and solicit their feedback. They’ll give you a good idea was to whether or not you have a good case and a receptive audience. Once this is done, ask for the official forms and submit your request.
- Appeal if Needed – If the review process comes back out of your favor, your final option is to appeal the decision. This can be a long drawn out process and you may wish to hire a lawyer.
If you’re successful in changing the opinion of your local county tax assessor, you could enjoy hundreds or even thousands of dollars in savings. Needless to say, the exercise can be well worth it. Just be sure to do your homework before putting too much work into it. If they’ve got a fair value already, you may end up wasting your time.
Patience is one of the most valuable assets you can have as a real estate investor, and it’s not limited to buying and selling properties. When you own a property, you can always refinance to get a lower interest rate on your mortgage.
Let’s say, for example, that the Federal Reserve lowers it’s interest rate to 0% in response to a global pandemic (once farfetched, no longer unfortunately…). Fixed and adjustable interest rates offered by banks would (and did) plummet. As a real estate investor, this is a perfect opportunity to refinance your property and enjoy significant savings over the life of your property.
When you refinance your mortgage, you take out a new loan to pay off the original loan. If you’ve built up a significant amount of equity, this can also be an opportunity to cash out some of that value for other investments. The new loan will bring with it a new interest rate and, if it’s lower than your current interest rate by a sizable enough margin, can save you a lot of money.
Refinancing does mean a new loan, which means new closing costs, so be aware of what that will do to your potential savings. Most banks will let you roll the closing costs into the new mortgage, so if you’re lowering your monthly payment by even a couple hundred dollars, it’s likely worth it.
So What Rate Is Worth Refinancing?
Most believe that it will be worth it to refinance your property if you can lower your rate by .5% or more. Any less and it depends on closing costs and the time it will take. Anymore and it’s a no-brainer.
You have more control over your finance related expenses than you think. Whether you want to refinance to a better rate, push down the appraised value of your property, or beef up your tax game, there is plenty of room to find savings outside of the traditional routes many real estate investors normally go to. It’s not all about lowering utility bills and self-managing. You’re running a business and as such, you have opportunities to lower the cost associated with the capital that business uses. Don’t forget it! It can mean big savings.