2 strategies to avoid paying taxes on your rental properties
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- Real-estate investors can lower taxes with cost segregation and 179D studies.
- Cost segregation accelerates depreciation, offering significant tax deductions for investors.
- 179D studies can maximize energy-efficient deductions for commercial property owners.
If you own a rental, you can likely lower your taxable income by deducting expenses associated with managing the property.
Business Insider spoke to Kristel Espinosa, a CPA and partner at JLK Rosenberger with expertise in real estate, about tax strategies and deductions that real-estate investors should pay attention to.
Espinosa pointed to two that can help investors minimize taxes on their rental income.
1. Do a cost segregation study to accelerate the depreciation of your property
One major deduction worth strategizing around as a real-estate investor is depreciation, which is the loss of an asset's value.
Investors can claim the value of depreciation as a tax deduction for the entire expected life of the property, which the IRS has determined is 27.5 years for residential buildings and 39 years for commercial buildings. To calculate depreciation on a rental, you divide the value of the property (not including the value of the land) by 27.5 or 39, depending on the property type.
A cost segregation study can help an investor accelerate depreciation by considering all of a building's internal and external components, some of which may qualify for a shorter depreciable life.
"You can now take this huge depreciation deduction instead of having to wait the whole 39 years to get that depreciation," said Espinosa. "You can take a big chunk in those first couple of years and basically put yourself into a loss position because the deduction is so large, and not have to pay any tax — and that loss generally carries over. If you don't need all of the loss in the current year, that loss carries over into subsequent years, so those losses could shelter the rental income from this property for years to come."
A cost segregation study isn't free — it can cost $5,000 to $15,000 — and it can take up to two months, but it could be worth looking into. Espinosa said that it's saved some of her clients over $1 million in taxes.
"I feel like this is often a missed opportunity just because a lot of people don't know about it or maybe they just don't want to pay the fee," she said. "But somebody needs to do that analysis for them and say, 'Hey, this is the fee that you're paying for this cost seg study, but these are your tax savings, so it's up to you if you want to do this or not. Is it beneficial?' And 99% of the time it's going to be a yes."
Courtesy of Kristel Espinosa
2. Do a 179D study to maximize the energy deduction
The 179D deduction is for commercial building owners who have certain energy-efficient components.
"A lot of these commercial buildings now, especially in California, are required to be energy efficient to a certain standard," said Espinosa, who is based in Irvine. "But our clients like to go above and beyond that sometimes and put in other energy-efficient structural components within their commercial buildings."
She recommends a 179D study for that type of client. It works similarly to the cost segregation study, in which you hire a specialist to analyze your building and its components.
She said one of her firm's clients recently did a 179D study and "found an easy $400,000 deduction."
"So, it's not a depreciation deduction, but it is a deduction that they're rightfully able to take. It's a federal-only deduction — California does not conform — but still, it saves them dollars, so they may want to look into that a little bit more if the property is an energy-efficient type of property."
The tax savings become more significant if you are a real-estate professional
If you qualify as a "real-estate professional," you could reduce your overall tax liability even more. This status allows you to offset rental against other income.
"Generally, if you're just a regular person like me who has a job as an accountant and is investing in real estate on the side, then the losses that I'm talking about offset the rental income from that property — but I can't take that loss from that rental and offset it with my W-2 income," explained Espinosa.
That's because they're two unrelated activities. However, if she was considered a real estate professional, "it all becomes one big activity," she said. "Those big losses from that cost segregation now can offset the commissions that you earn as a real estate agent or whatever other income you earn in real estate because now it's no longer passive in nature."
Being a real-estate agent automatically deems you a professional, but if you don't have that license, you may qualify if you meet certain requirements, including spending more than 750 hours on real-estate activities.
"I feel like this is an often abused area," noted Espinosa. "You can have other jobs but you just have to be able to show that to the IRS if ever audited that the real-estate business really is your main thing."
She recommends documenting everything, from how you spend your working hours to the mileage you drove to visit properties, even if you aren't a real estate professional: "If you're holding real estate and renting it out and taking deductions on it, you should always document everything and always track your expenses."
If you meet the requirements, "Then, of course, designate yourself as a real-estate professional," she said. "It obviously has huge benefits. But then also be aware that this is a highly scrutinized area by the IRS too, so that's why you want to have your documentation in place."