Whether you own rental property, a home, have both, or are thinking about taking the real estate plunge, there’s a lot you need to know if you want to maximize your profits. That includes understanding critical parts of the tax code concerning your investment.
Isn’t that what your accountant is for, you may ask? As a financial planner and lifetime real estate investor, I’ve found there can be a big disconnect between property owners and their accountants. You may be leaving thousands on the table year to year, and potentially tens of thousands when you sell or exchange.
“Tax speak” can be confusing and vague. I’ll explain what you need to know as quickly and painlessly as possible since few enjoy reading about taxes. I hope to help you bridge the gap between you and your accountant.
Do I Need an Accountant?
Do you prepare your own taxes? If your home is your only real estate investment, you’re an employee who’s good with numbers, and your tax return is otherwise straightforward, you may be able to get away with it.
If you own rental real estate in addition to your home or have rentals and rent your home, your tax return is much more complicated. If you don’t already have one, I advise hiring an accountant who routinely files tax returns for clients with income property.
Tax Blitz for Homeowners
Unfortunately, if your home is your only real estate investment, there’s a lot less to know about taxes than there used to be. The Tax Cuts and Jobs Act of 2017 gutted a lot of tax benefits enjoyed by homeowners prior to its passage.
There’s still a lot to know. I narrowed my list down to 3 key tax topics that will help you maximize your profits from the eventual sale of what very well may be your most valuable asset:
- Tracking Basis
- Repair versus Capital Improvement
- Future Tax Breaks?
Tracking Basis
The basis in any property you own, whether you declare it as your home or rent it, usually starts out as the price you paid for the property. Any capital improvements you make should be added to its basis during your ownership.
How exactly do you “add it to the basis?” The IRS doesn’t have a website where you can record this information, nor is there a place on your yearly tax return to document these capital improvements.
Some accountants won’t even ask about capital improvements to a home since that’s not a part of preparing your yearly return. A good accountant will ask about capital improvements and take it upon themselves to record the amount but even that’s not good enough.
By law, you can only add capital improvements to your basis if it’s both recorded and you have proof in the form of receipts and contracts that add up to your claimed total.
When you eventually sell your home, it’s your basis, along with the home capital gain exclusion discussed last month, that is subtracted from your selling price to determine your capital gain. The bigger the basis the bigger the chunk of change you get to walk away with. That’s why tracking basis is so important!
New homeowners may be unaware of the above requirements and improvements get lost in the shuffle. Take it upon yourself to correctly record and store this “basis” information right from the get-go until you sell. Personally, I prefer clutter-free electronic storage, which is accepted along with paper copies as proof by the IRS.
If your accountant tells you they’re going to capitalize a housing expense, they mean the same thing—they’re adding it to your basis.
Repair versus Capital Improvement
Sometimes there’s a fine line between a house repair, which you can’t add to your basis, and a capital improvement which you can. Understanding the nuances can save you a bundle in taxes come the year of your sale. Small amounts, like one of mine documented below, can add up to large numbers over the years.
I made a fence improvement to our 5-acre farm’s boundary recently. The weather this past winter caused around 100 yards of the fence to lean badly. I temporarily propped it up and then a few weeks ago made a proper repair, costing me hundreds of dollars in materials (concrete, 4x4s, metal posts, etc…).
I saved my receipts, recorded it as a capital improvement, and added it to our property’s basis. Even though it sounds like a repair, I added a good 40 years to the life of that part of the fence (I tend to overbuild).
Anything you do that substantially prolongs the life of an improvement made to your property, whether it’s to an outbuilding, house, or fence, is considered a capital improvement. Save your receipts and talk it over with your accountant come tax time if you’re unsure.
What about my labor? That’s called sweat equity. Like your basis, you realize no monetary benefit until you sell your house.
Future Tax Breaks
That’s why homeownership is smart if it’s affordable and decent growth is anticipated, despite the lack of tax breaks enjoyed previously. But wait, those tax breaks I keep speaking of, those enjoyed prior to 2018, may return!
Permanent changes to the tax code are harder to pass through Congress than ones that are temporary. That’s why a lot of tax legislation that passes, including the Tax Cuts and Jobs Act, are temporary. Unless Congress acts, the provisions of the Act will expire, and starting in 2026 all those tax breaks for homeowners return. Stay tuned.
Tax Blitz for Landlords
You just got done reading how a lot of the year-to-year tax breaks homeowners used to enjoy are unavailable today because of the Tax Cuts and Jobs Act. If you’re a landlord, nothing has been taken away. Unlike homeowners, you not only get to write off every penny of your property tax and loan interest but a host of other expenses too. You even get to depreciate your buildings, a paper write-off that reduces your tax burden even more.
Note that what I said about tracking basis in the homeowner’s blitz applies to rental property too, so be sure to save all that capital improvement documentation. As far as calculating depreciation is concerned, that’s a big reason why you hired your accountant. I’ll stick with what you can do year to year to improve your bottom line:
- Control Expenses
- Increase Income
- Understand the Capitalization Rate
Control Expenses
If you recall, my number 1 tenet (of my 5 tenets) of successful stock investing is to keep your investing expenses as low as possible. The same goes for real estate investing. That’s why I don’t love REITs (Real Estate Investment Trusts) and real estate mutual funds: Too much of your investment goes toward expenses which you have zero control over.
It’s why I prefer direct real estate investing over indirect ownership methods, even though it’s a bit more work. All the expenses flow through you. Plus, you enjoy all the tax benefits because it’s you who’s in control. Just be sure you know what you’re getting into. Remember, not everyone is cut out to be a landlord.
What about property management? Unless you’re made of money or don’t care about your bottom line, you won’t be able to afford it. We’re talking about a side hustle here; one we want to run like a business. Only after an increased inventory of properties and enhanced cash flow can you even think about hiring a property manager.
You don’t have to do everything, but the more of the following you’re able to successfully perform, the better your bottom line:
Increase Income
Basing rent increases on a particular index, like the consumer price index or other metric, is an effective way to keep your rents at the market rate. It can also help justify those increases to unhappy tenants.
How else can you increase the income from your property? Always be on the lookout:
- Add an extra bedroom to a larger unit
- Increase your building’s curb appeal
- Add a laundry room
- Convert a community garage into separate lockable spaces
- Work on retaining good tenants
You can quantify increases in income and decreases in expenses by understanding the capitalization rate.
Understand the Capitalization Rate
The cap rate is a simple formula; There are only 3 variables. Net Operating Income (NOI) equals all revenue from the property minus all necessary operating expenses. The cap rate measures the return you’re receiving from the value of the property without considering any financing.
Increasing income and/or reducing your expenses is reflected in a higher NOI. That in turn increases your property’s capitalization rate and the value of your property, as illustrated below.
Get to know real estate agents in your area that deal in rental properties. They can be valuable sources of information and will be forthcoming because they want your future business. Good ones will be able to tell you what the average cap rate is for your building’s neighborhood as well as surrounding areas.
If they don’t know what you’re talking about, ask them to find out the NOI of rental properties in proximity to yours that sold recently. (If they’re still giving you a blank stare, it’s time to find another real estate agent.) Once you have 2 of the 3 variables (NOI and market value) of comparable properties and through the magic of math, you or your agent can determine at what cap rate income properties in your neighborhood are selling for.
Plug in your neighborhood’s average cap rate with your own NOI, and you’ve got a very accurate measure of your property’s market value. Now raise your NOI a few thousand. Look what happens to your market value. That’s why as a landlord I want you to concentrate on increasing your income and decreasing your expenses. Each boost NOI and increases your market value, as well as enhancing your cash flow.
Besides better understanding the consequences of your positive actions, this simple formula can be used to great advantage when looking for an income property to purchase. Once you have the average cap rate for a neighborhood based on recent sales, you can more easily determine whether an asking price is justified.
Although there are other variables to consider when purchasing an income property, a property that has a higher cap rate than average might be an indication of an underpriced property.
When looking to purchase income property, that’s why it’s so important to verify a seller’s NOI numbers. Inaccurate numbers will affect the capitalization rate and subsequently the purchase price too.
[Best Money Newsletter originally published 2023 0801 on the Sturgeon Moon]