Real estate investors have always had unique opportunities to build wealth through tax-efficient investing. But as tax laws continue to evolve and the IRS increases its scrutiny in certain areas, the cost of making a tax mistake can be significant.
Given the urgency that often surrounds real-estate decisions, it can be easy to make one. Too often, investors focus solely on acquiring the next property while overlooking planning opportunities that can save thousands of dollars in taxes.
Whether you’re a first-time investor or a seasoned property owner, avoiding the following mistakes could help you maximize your after-tax returns.
1. Waiting until year-end to think about taxes
One of the most common mistakes we see investors make is to treat tax planning as a December activity.
Tax planning—i.e., thinking through entity structures, cost segregation studies, major improvements, Section 1031 exchanges, retirement contributions, and the like—should happen ahead of every major transaction you make. This gives you more control over your tax outcomes. Waiting until the back end of a transaction or the end of the year is often too late.
Investors who achieve the best tax outcomes typically meet with their tax advisor regularly throughout the year. They aren’t simply dropping off documents during tax season.
At Abdo, we schedule monthly meetings with our larger real estate clients. This allows us to stay on top of their portfolios and help them plan for taxes on the front end of their acquisitions or sales.
The fix: Schedule periodic tax planning meetings with your tax advisor throughout the year, especially before major acquisitions, dispositions, or refinancing transactions.
2. Missing cost segregation opportunities
Many investors continue to depreciate an entire property over 27.5 or 39 years without considering whether portions of the property qualify for accelerated depreciation.
A properly completed cost segregation study can identify components that qualify for significantly shorter recovery periods. This can create an opportunity for substantial front-loaded deductions and improve cash flow.
It can be easy to put off exploring cost segregation opportunities or assume a property is too small for a study, but it’s almost always worth discussing with your tax advisor.
For example, after one of our clients sold a property, we reviewed their portfolio and found they could conduct a cost segregation study on another property to offset the gains on the sale.
The fix: Consider a cost segregation analysis any time you acquire, construct, or significantly improve a property.
3. Failing to qualify as a real estate professional
Many investors incorrectly assume they cannot qualify for real estate professional status. Others believe they automatically qualify because they own rental property.
The reality is more nuanced.
For qualifying taxpayers, losses that would otherwise be limited as passive losses may become deductible against ordinary income. The potential tax savings can be substantial.
However, the IRS continues to closely examine claims of real estate professional status. In many cases, inadequate documentation leads to challenges during an examination.
The fix: Maintain detailed records of your time spent in real estate activities and discuss qualification requirements with your tax advisor before filing your return. Real estate activities can include construction, development, acquisition, property management, and brokerage-related work.
4. Ignoring state and local tax exposure
State and local tax compliance has become an increasing area of focus for both businesses and tax authorities. Many investors own properties in multiple states but fail to consider the resulting tax obligations. And some states have exceptionally complex rules and filing requirements.
Owning rental property across state lines can create filing requirements, income tax obligations, withholding requirements, and other tax considerations that investors may not anticipate.
As state tax authorities increase enforcement efforts, investors are finding that compliance issues identified years later can become expensive to resolve. Most state authorities can go back years to apply penalties and interest for an instance of noncompliance.
The fix: Review your state filing footprint annually and evaluate whether new acquisitions create additional reporting requirements. Consider analyzing the tax requirements of states in which you plan to acquire property.
5. Using the wrong entity structure
Many investors use a particular entity structure because someone told them they should. Others continue operating under structures they established years ago without evaluating whether those structures still align with their goals.
The ideal structure depends on several factors, including:
- Asset protection considerations
- Estate planning objectives
- Financing requirements
- Number of investors involved
- Long-term exit strategies
- Administrative complexity
An entity structure that worked for one rental property may not be appropriate for a growing portfolio.
The fix: Periodically review your ownership structure as your portfolio evolves. The best structure today may not be the best structure five years from now.
6. Losing valuable records and documentation
Real estate investing generates an enormous amount of documentation.
Closing statements, renovation invoices, loan documents, capital improvement records, and depreciation schedules all play critical roles in determining future tax outcomes.
Unfortunately, many investors only realize the importance of these records when selling a property years later. Missing documentation can result in lost deductions, higher taxable gains, and increased audit risk.
The fix: Create a centralized system for storing property records and maintain documentation throughout the life of the investment.
7. Focusing only on acquisition and not on exit planning
Successful investors are often highly disciplined when evaluating purchases, but few spend time planning for eventual disposition. Yet one of the greatest benefits of investing in real estate is being able to control your exit.
Whether a property is sold, exchanged, gifted, or transferred upon death can dramatically impact your tax outcome.
This is why it’s important to think about exit planning, too. Consider evaluating depreciation recapture, capital gains exposure, installment sales, charitable planning, and Section 1031 exchanges, which allow you to defer the full gain of the sale, well before a property is listed for sale.
The best tax outcomes rarely happen by accident. They typically result from years of intentional planning.
The fix: Begin discussing exit strategies years before you anticipate selling a property.
Optimize the tax benefits of your real estate investments
Real estate remains one of the most tax-advantaged asset classes available to investors, especially considering recent tax legislation. Maximizing these benefits, however, requires thoughtful planning and execution.
The investors who achieve the strongest after-tax returns are often not the ones who find the best deals. They are the ones who maintain proper documentation, incorporate tax planning into every major investment decision, and avoid costly tax mistakes.
If you’re unsure whether you’re making any of these mistakes, now may be the right time for a tax planning review with your CPA.
Kevin Kalal is partner and real estate and construction leader in the Edina, Minnesota, office of accounting and business advisory firm Abdo.
