As a real estate investor, you may be looking to maximize income and minimize taxes. Those are desirable goals, and there are strategies you can use to help work toward them. Having expert professional financial and tax advice is a good way to ensure that you are taking advantage of all the potential opportunities available to you. One possible benefit of investing in real estate is that the deduction can sometimes lower other income in addition to the revenue from the real estate investment.
How do I Report Income and Expenses?
In any case, investors seeking to maximize deductions will need to use the itemization forms that the IRS offers. For example, Form 1040 Schedule E is required for reporting income and expenses from rental real estate, partnerships, S corporations, estates, trusts, and other structures. Each Schedule E can report the details for up to three properties, including income received and expenses paid out (operating costs, insurance, taxes, interest paid, depreciation, and more).
Limitations on Deductibility
Other factors impact the deductibility, and you may need to add more forms. For example, if rental income is less than the expenses, the passive activity rules and at-risk rules come into play. IRS Form 8582 calculates passive activity loss limits. Ordinarily, passive activities are any trade or business operations in which you did not materially participate but from which you obtain income, and rental activities, whether or not you actively participate. The provision includes an exception for rental activities if you are an active participant and don't have any other passive activities. You must meet other conditions for the exception to be allowed, so it's wise to seek advice from a tax professional.
Another potential limitation is the value of funds "at-risk" according to the IRS definition. For this, use Form 6198, At-Risk Limitations. Only an amount that was actually at risk is deductible, and this determination is necessary before calculating whether expenses are deductible under the passive income rules.
How Do I Determine Active Participation?
The IRS allows various means of satisfying the active (material) participation rule, including any of the following:
- You participated in the activity for more than 500 hours in the tax year.
- You were essentially the only participant.
- You participated for at least 100 hours in the tax year, and more than anyone else.
- If an activity is considered a significant participation activity, you must participate for more than 500 hours.
- You were an active participant for any five of the last ten years.
- If the activity is a personal service activity in specific fields in which capital is not material, and you met the definition of active participation in any three previous tax years.
- You were a regular, continuous, and substantial participant.
What Else Can a Real Estate Investor Deduct From Taxes?
As referenced previously, the Form 1040 Schedule E includes some of the expenses commonly associated with rental property. However, some other forms may be needed (for example, other interest expenses will require Form 4952). Some costs that rental property owners may want to consider are the home office deduction if you use a dedicated portion of your home strictly for your business.
Direct expenses like traveling to the rental property, maintenance, and acquiring tenants are usually eligible. Repairs might be maintenance but could cross the line into an improvement that would need to be depreciated rather than deducted, so this is another excellent example of something to discuss with a qualified tax advisor.
