Archive for Investments – Page 2

Maximize Your Tax Deductions on Business Repairs

When you own business properties, they will occasionally require repairs; that’s just a fact of business ownership. So, whether you need to make repairs on your place of business or your rental buildings, keep these simple truths in mind:

  • You can either increase your net worth with tax-favored repairs.
  • Or, you can decrease your net worth with tax-impaired improvements.

Now, which would you prefer?

Boosting Your Net Worth with the Right Fixes

The fixes that you can label as repairs are vastly more valuable to you than those labelled improvements. That means you need to know the difference between the two so you can a real monetary difference. Of course, it’s important to note that this only applies to an office or rental building that you own.

Fortunately, the IRS released a guide on this subject titled Capitalization v Repairs[1]. Without this guide, some tax deductions linger in an indeterminate gray area, which can be infuriating when it comes time for tax preparation. If you don’t know how the IRS classifies a particular fix, you lose control of your money. However, with the right planning, you can classify particular fixes as repairs and regain that financial control.

Here’s an example of how tax-favored repairs work:

  • Scenario 1: You put an entirely new roof on your office building. Uh-oh! Now you have to depreciate that roof over thirty-nine years, which means you have lost quite a bit of money up-front.
  • Scenario 2: Instead of completely replacing the roof on your building, you replace thirty-five percent of the roof one year, twenty-five percent of the roof a couple years later, fifteen percent of it a few years after that, and then twenty-five percent the following year. Each of those repairs can be deducted immediately, leaving you with a hefty financial advantage.

Defining a Repair

Do you see the difference in the above scenarios? Repairing is maintaining or mending. It is a fix that keeps a property running in its ordinary and efficient operating condition. A repair[2] does not 1) add to a property’s value, or 2) prolong the life of the property by an appreciable measure. You see, a repair ensures that you can continue using a property for the purpose you obtained it for, as opposed to increasing the value for a possible sale in the future[3]. An improvement, on the other hand, is a fix that 1) increases the property’s value[4], 2) prolongs its useful life substantially[5], or 3) modifies the property for a novel use[6].

Take a look at this actual situation to get an idea of how these definitions might play out (numbers are not in today’s dollars). A man purchased a four-unit apartment building (with one tenant residing) that was in poor repair for $30,000 and spent $6,247 for a contractor to fix it up. The contract work included removing tree limbs that were rubbing the roof; repairing water damage; repairing electrical wiring; cleaning the carpets, floors, and exterior; repairing the front porch; and, installing new cabinet doors and new countertops.

When the owner was audited, the IRS deemed the entire amount an improvement. The owner, however, disagreed, and the Tax Court allowed $5,000 worth of repair deductions[7]. The court only required the owner to capitalize $1,247 for the new cabinet doors and countertops.

Why did the court side with the building owner? First, the court noted that a tenant was living in the building. This meant the property was commercially active at the time of the fixes. If you’re repairing a rental property, having tenants in the building is beneficial to your claim of making repairs. Second, the $5,000 in repairs was not considered a large amount of money compared to the initial $30,000 spent to purchase the property. That is, the court could justify the expense as repairs rather than improvements to increase the property value.

Note: There is no defined amount of money that distinguishes a repair from an improvement. Two people could make the same fixes for the same amount of money and get differing tax results. That is why it is important for you to document the facts surrounding your repairs and present those facts when making a case with your tax preparer.

Tips on Making a Case for Repairs

By following a few best practices, you can make it easier on yourself to get the right tax deductions. A good way to get a favorable result for deductions on repairs is to get separate invoices for repairs and improvements[8]. This is especially important when you are carrying out a large renovation project. The IRS specifically states in its audit technique guide that repairs are not considered repairs when they are made as part of a general rehabilitation project[9]. So, keep those invoices separate! In fact, you’ll give yourself a lot fewer headaches if you just hire different contractors to do the repair work at different times from the improvements.

Here are some additional tips:

  • Always Document the Reasons for Your Repairs—Repairs, by their nature, are preceded by an event that indicates their need. For instance, you repair a water pipe because it begins to leak, or you repaint an exterior because the weather has faded it. Record these reasons as evidence of the need for repairs.
  • Fix Only Small Parts at a Time—This is pretty self-explanatory. When you replace something in its entirety (i.e., putting on a new roof, replacing an entire wall, installing new flooring), you are making an improvement[10]. When you focus on simply fixing a part of that roof, wall, or floor, you are making a repair[11].
  • Use Comparable Materials—If you want your claim for tax deductible repair work to be accepted, you should replace worn materials with those of similar, or even less expensive, quality[12]. If you’re using higher quality materials, the work may be considered an improvement[13].
  • Consider the Reason for the Repair—Another aspect to consider when making a case for fixes to be considered repairs for tax purposes is the condition of part being fixed up. A repair can only be made to something that is worn out, deteriorating, or broken[14]. If you’re not restoring or replacing a damaged part of the property, or if work expands to parts of the property that are not damaged, it becomes an improvement.

What’s the Main Concern?

Why is the IRS so particular about whether you are making repairs or improvements? They suspect you may buy a property to renovate, and then write off the renovation as repair costs. In its audit technique guide, the IRS distinguishes between money used to “put” or to “keep” the property in efficient operating condition[15]. Simply stated, if improvements need to be made in order to put the property in efficient operating order, then they are capital improvements. But, if they are only made in order to keep the property in efficient operating order, then they are repairs and are tax deductible.

This is not to say that you should not consider making improvements to your properties. Indeed, if you plan to sell, improvements may be exactly what you need. However, this article is a helpful guide for how to get the most out of your tax deductions when you are attempting to repair the buildings you still use. With proper documentation, you can designate whether the work you have done on your buildings is considered a repair or an improvement, and that means you have the power to take control of how much of your money goes to taxes.

  1. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023.
  2. Reg. Section 1.162-4.
  3. Illinois Merchants Trust Co. v. Commr., 4 B.T.A. 103, 106 (1926), acq.
  4. Reg. Section 1.263(a)-1(a)(1).
  5. Reg. Section 1.263(a)-1(b).
  6. Also see Reg. Section 1.263(a)-1(b).
  7. Roger Verl Jacobson v Commr., TC Memo 1983-719.
  8. E.g., Allen v Commr., 15 T.C.M. 464 (1956).
  9. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023.
  10. Reg. Section 1.162-4; e.g., Ritter v Commr., 47-2 USTC Section 9378 (6th Cir. 1947) (new roof).
  11. E.g., Kingsley v Commr., 11 B.T.A. 296 (1928) (patching roof), acq.
  12. E.g., Illinois Merchants Trust Company v Commr., 4 B.T.A. 103 (1926).
  13. E.g., Abbot Worsted Mills, Inc. v Cagne, 42-2 USTC ¶ 9694 (D. N.H. 1942).
  14. Sanford Cotton Mills v Commr., 14 B.T.A. 1210 (1929) (portion of decayed floor replaced).
  15. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023.

Are You a “Dealer” or “Investor” for Tax Purposes?

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment.
  2. Assuming the real estate profits were your only income.
  3. Tollis v Commr., T.C. Memo 1993-63.
  4. Sanders v U.S., 740 F2d 886.
  5. IRC Section 1221(a)(1).
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171.
  7. S & H, Inc., v Commr., 78 T.C. 234.
  8. S & H, Inc., v Commr., 78 T.C. 234.
  9. Revenue Ruling 57-565
  10. IRC Section 1237.
  11. Miller v Commr., T.C. Memo 1962-198.
  12. Hancock v Commr., T.C. Memo 1999-336.
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969).
  14. Suburban Realty Co. v U.S., 615 F2d 171.
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548.
  16. Mathews v Commr., 315 F2d 101.
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552.
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3.
  19. Rymer v Commr., T.C. Memo 1986-534.
  20. Estate of Mundy v Commr., 36 T.C. 703.
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963).
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960).
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958).
  24. Metz v Commr., 14 T.C.M. 1166.
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969).

Tackle the Gray Area and Claim a Home Office Deduction on Your Rental Property Business

For those of you who run a real estate rental business, you may find that the IRS is a little tougher on you about claiming a home office deduction. The sticking point is that, depending on your circumstances, the IRS may consider your real estate business an investment rather than a business. In order to claim this deduction, your home office must be connected to a “trade or business”. So, the trick is to provide documented evidence that your rental endeavors are a business you run.

The Gray Area

A home office can save you thousands on taxes because you are able to deduct a percentage of your mortgage interest, property taxes, and even utilities as business expenses. However, when you’re lurking in the shadows of this gray area in tax law, you can find yourself arguing with an auditor who simply does not believe that your deduction is legitimate.

That is exactly what happened to Dr. Edwin Curphey, who owned a rental property business and had his home office deduction rejected. He ended up taking his case to court and winning his deduction.

It usually seems like the IRS has no end to specifications and rules to follow. However, in the case of deducting a home office for your rental property business, the law is fairly vague. This gray area leads some auditors to interpret such situations in different ways, so you have to be prepared with the right knowledge when tackling this deduction.

Unfortunately, no set method exists for proving your claim. You can, however, piece together information that will help in making your case. In order to determine whether you qualify for the deduction, your best bet is checking out precedent cases to see who has previously won the deduction and who has not.

Gray Area Guidelines

What’s the main difference between an investor and a business owner? It’s pretty simple. An investor collects money without having to perform any work, but a business owner actively works with a property. That means to be considered a business, you need to show the IRS that you do more than simply handle money[1].

Here’s where the fuzzy requirements come in. In order to qualify, you have to present evidence of activities that indicate you are doing work with your rental properties, but there is no definite set of activities that are required by the IRS. Some actions that indicate actual business activity may include[2]:

  • Management
  • Making repairs
  • Performing cleaning tasks
  • Advertising
  • Resolving tenants’ problems

You may not do all of these in association with your real estate rental business, but your chance of making a successful deduction increases with the more you do. The good news is you can still claim your rental property income on the Schedule E (just like investment property) while making the case that it’s a business. This means you’ll be able to avoid the self-employment tax, unless you offer your tenants significant services, such as a housekeeper[3]. In that case, you’ll need to use the Schedule C[4].

What If You Run Multiple Businesses?

If you run multiple businesses, you may be using the same home office space for all of them. In that situation, you’ll have to be extra careful because each business has to meet the home office requirements in order to qualify your office space for a deduction[5]. When one of the businesses does not qualify, you should find a separate office space for it, if possible. Otherwise, you’ll lose your legitimate deduction for the business or businesses that do qualify!

Three simple requirements must be met for the home office deduction:

  1. The home office must be your principal place of business;
  2. You must use it regularly; and
  3. The space must be used exclusively for business purposes.

In general, the requirements for deducting a home office are not hard to meet. Owning rental property, however, is a little different from other businesses. Don’t let a misunderstanding of the rules keep you from claiming your legal deductions. If you’re operating your real estate rental business and performing regular business activities for it, then it qualifies, regardless of whether you have another full-time job.

  1. Neill v Commr., 46 BTA 197.
  2. Curphey v Commr., 73 TC 766.
  3. Reg. Section 1.1402(a)-4(c)(2).
  4. Schedule E Instructions (2013), dated Dec. 4, 2013, at p. E-5 (under “Line 3”).
  5. Hamacher v Commr., 94 TC 348.

Passive-Loss Rules Got You Trapped? You can Release Rental Property Tax Losses

If you’re feeling the pain from calculating your rental property loss deductions and finding that you can’t get some of that money back, you can thank lawmakers from 1986. That’s when the passive-loss rules came into being. These laws really complicated matters for taxpayers, but this article can help you to understand the ins and outs.

How Passive-Loss Rules Work

Basically, lawmakers have given you three possible tax buckets for any given taxable activity:

  1. Portfolio of stocks and bonds
  2. Active business activities involving material participation
  3. Passive-losses for rentals and other activities you don’t materially participate in

We’ll primarily look at the last one with this article. You’ll be happy to know that you do have some options for getting around the passive-loss problem. With the right knowledge, you can see tax benefits from your rental losses.

Before we delve into the solutions, let’s get an understanding of why you may have issues deducting your rental property losses. In order to get the tax benefit from your rental property loss, you (or you and your spouse) have to meet one of two requirements. To meet the first requirement, you must have passive income, such as from other properties or another source. Otherwise, you have to qualify as a real estate professional and actively participate in your rental property business.

Given those requirements, here’s an example of how your rental property losses can end up trapped and unable to be deducted. For the example, you have only one rental property (i.e. you have no other passive income), and you do not qualify as a real estate professional for tax purposes. If your property has produced a tax loss of $10,000 each year for the past six years, and your taxable income is $180,000, you can’t deduct any of those $60,000 in losses because you don’t meet either of the above requirements, and they can’t be deducted from either of the other income buckets.

Your Options

Let’s take a look at the three options you have for navigating these passive-loss rules. It turns out that even if you don’t meet the above requirements, you may have an opportunity to deduct your losses in certain scenarios.

  • Get Full Loss BenefitsTaxpayers who have a modified adjusted gross income of up to $100,000 can deduct all of their rental losses up to $25,000.[1] As your income rises above $100,000, your deduction is reduced by 50 cents per dollar, and once you reach a modified adjusted gross income level of $150,000, you lose this ability to claim losses easily.[2] For a practical example of how this works, let’s say your modified adjusted gross income from your business was $85,000, and you had rental losses of $21,000. In this case, you would be able to deduct the full $21,000.
  • Waiting for the BenefitRemember the $60,000 that were trapped in the example above? It turns out that you don’t just lose all chance of benefiting from those accumulated losses. They are still tax-deductible, but you have to find a way to release their ability to be deducted. In fact, here are four possible ways to get that money out of waiting:
  1. Change the rental property from passive to non-passive. If you’re the sole owner of your business, and you also own 100 percent of the rental property, you can simply convert half the rental property for business use (such as office space). Now 50 percent of you trapped losses can be released ($30,000) for use against the business income bucket[3]. If you operate as an S corporation, you’ll have to make a self-rental election.
  2. Produce additional passive income. If you produce, for example, $6,000 in passive income, you can release $6,000 of the trapped $60,000. Now, you just have to wait to release the other $54,000.
  3. Qualify as a real estate professional and prove your material participation in your real estate business. This option cannot release funds that have been waiting to be released because your qualification as a real estate professional is evaluated on a yearly basis. However, by qualifying, you are able to release your losses for the current tax year. So, the $10,000 for the year you qualify as a real estate professional will be offset against your business and portfolio income buckets. Other losses will have to be released using one of the other solutions.
  4. Sell your property. This option is further explained below.
  • Releasing the Full AmountIf you don’t meet the modified adjusted gross income threshold to take full advantage of loss deductions, there’s actually a very easy way to release the full $60,000 of our example losses. All you have to do is sell 100 percent of the property. When you sell to a third party, you can deduct the entire $60,000 at once. Here’s how you might handle this on your tax return:[4]
  1. You list your capital gain or loss on IRS Form 4797. It will be listed with your other Section 1231 gains and losses. A net gain will be taxed at the tax-favored rates of up to 15 percent, and a net loss will be limited to $3,000. But, don’t worry—anything over that amount can be carried forward.
  2. You also list any gain that is attributable to real-property depreciation (Form 4797). This will be taxed at the real-property depreciation recapture rate on Schedule D (up to 25 percent).
  3. You put the $10,000 loss for the current tax year on Schedule E.
  4. And, here’s the best part. You put the prior $60,000 of tax loss (in addition to the current year’s $10,000) on Schedule E, which finally ends up on your Form 1040 and the entire $70,000 offsets all your income.

To break it down for you, when you sell your property, you get to snub the passive-loss rules and pretend like they don’t even exist!

Passive-loss rules are frustrating, but know that you can eventually deduct your losses. You can even elect to group together multiple properties and use these exact same solutions. Getting the most benefit from your tax return is all about planning ahead. Now that you know how to get around the passive-loss restrictions, you can start planning for the techniques that work right for you and your properties.

  1. IRC Section 469(i).
  2. IRC Section 469(i)(3)(A).
  3. Reg. Sections 1.469-9(e)(4), Example (ii); 1.469-1(f)(4)(iii), Example 4.
  4. Instructions for Form 8582 (2011), revised Jun. 8, 2012, ps. 7-8.