7 Common Myths About Rental Property Taxation—Dispelled
Time and time again, I see people asking tax questions and receiving conflicting answers. The confusion stems from our overwhelming tax code. Companies make billions of dollars helping you “simplify” your taxes with software and advice. One big box tax retailer is the top lobbyist for making the tax code more confusing so that you have a perpetual reason to buy their products.
Frankly, I wish the tax code was simple. People like you could focus purely on business productivity. People like me would have to start businesses that add real value to the world (rather than adding value in terms of tax savings). I feel this plays into why I produce so much free content. I really want to break the tax code down for you as much as possible.
Today, I’m going to dispel tax myths related to real estate investors. I hope that you’ll find clarity with commonly debated tax items.
7 Common Myths About Rental Property Taxation—Dispelled
Myth #1: You must have a license to be a real estate professional.
This is a common question I see pop up over and over. Real estate investors believe that in order to qualify as a real estate professional, they must first obtain their real estate license.
In order to put “real estate professional” on LinkedIn, you may indeed need your real estate license. But to qualify for the real estate professional tax status, all you need is time.
For those that don’t know, qualifying as a real estate professional for tax purposes allows you to deduct passive losses generated from your rental activities that would have otherwise been suspended. For all my high earners out there, you know the pain of not being able to claim your suspended passive losses. The real estate professional status helps you get around that annoyance.
The rules are simple: Work 750 hours in a real estate capacity, and more than half of your time must be in real estate. You do not have to work on your rentals in order to hit the 750 hour requirement. You can be a full-time real estate agent, property manager, contractor, etc. and meet the 750-hour rule. However, you cannot have a full-time job unrelated to real estate and qualify as a real estate professional due to the “more than half your time” rule.
Those are all the requirements you need to qualify as a real estate professional for tax purposes. This is an annual election, so on January 1, your prior year hours are wiped out and you need to start fresh.
But here’s the catch. Once you qualify as a real estate professional, you must then demonstrate that you materially participated in your rental real estate activity. There are seven tests for material participation; the most common is the 500-hour rule. So aim for spending at least 500 hours on your rental real estate if you want to take passive losses that would have otherwise been suspended.
The key is to log and record your time as it relates to real estate. What type of activities should be recorded? I dive into that here.
Stage 2: You (Buyer A) Find an Outside Investor (Buyer B)
Myth #6: Using 529 plans is great for real estate investors.
I wrote an article that should have killed the notion that 529 plans are good ideas for investors and business owners here.
I received negative comments from people in the finance industry (surprise, surprise) and from folks who likely didn’t understand the strategy I was trying to demonstrate.
In fact, 529 plans are good investment vehicles for folks who want to save for college but do not own investment real estate or a business. Contributions to a 529 plan are generally deductible on the state level and never deductible on the federal level.
The problem is twofold: They stink in terms of tax minimization, and you can generally only withdraw funds for qualified education expenses without paying penalties.
I like flexibility. The 529 is inflexible. Thus, I advocate against the 529 plan.
Instead, we advocate for the use of Roth IRAs for college savings vehicles. You are able to withdraw Roth IRA contributions tax-free and penalty-free at any time. We don’t have to use the monies for a specific purpose, and we don’t get penalized if we choose to move the funds elsewhere. That’s flexibility.
A note on retirement plans: I am not advocating that you should tap into retirement plans. I am showing you a way that you can build wealth for your child and save for college while maintaining flexibility. This is also an “either/or” scenario—with the 529 or the Roth IRA. If you have the funds to contribute to a 529 and run the Roth IRA strategy I’m about to disclose, then use the 529 for college savings and the Roth IRA for your child’s future retirement. Otherwise, use the Roth IRA for college savings.
Here’s the strategy:
Hire your child to work in your business or on your investment portfolio. Pay them less than or equal to the standard deduction (currently $6,350). Transfer up to $5,500 of that payment into a Roth IRA in the child’s name.
You get a tax deduction for the payment to your child much like you would if you were to pay a contractor. Your child pays $0 taxes on the payment because children have a FICA exemption, and if someone earns less than the standard deduction, they don’t have to file a tax return.
So, you’ve literally created a tax-free transaction by moving money to your child. Additionally, your family wealth increased via your tax savings on the deduction you receive for paying for services/labor.
On top of that, we now have the funds in a tax advantageous vehicle, the Roth IRA. You know that you can withdraw the contributions tax-free and penalty-free. So, now you have a college savings fund, and should the child choose not to go to college, you have a house fund, wedding fund, retirement fund, or whatever else you want to call it.
But overall, you have flexibility, and to me, that’s priceless.
Myth #7: Following the BRRRR(RRR?) strategy allows me to refinance my property and continue to deduct mortgage interest.
The much-talked-about buy-rehab-rent-refinance-repeat (BRRRR) method is great for wealth building. It’s not great for taxes unless you have another property readily available to move the refinanced funds into.
When you refinance a property and take cash out, we must “trace” the cash to see where it is applied. When you let it sit in your bank account or if you buy some sort of personal item with the cash, the interest applicable to that cash becomes non-deductible from a tax perspective. We can only deduct interest on refinanced cash when it is applied to a rental or business activity.
So, you have a $100,000 home with $40,000 in equity. You find a lender who will lend 80%, so you lock that note up, leaving you with $20,000 in equity and $20,000 in cash.
The interest on the $20,000 in cash is non-deductible until you apply it to a rental property or a business activity. Please make sure you plan for this; otherwise, you’re missing out on easy money.
Which of these myths is most surprising to you? Any questions about these tax items?