We’re just going to go ahead and say it… most real estate investors haven’t got a clue when it comes to creating a comprehensive tax plan. And we kinda get why. Tax planning is difficult and requires some professional help—and we mean more than just Google.
So we asked our friends at Estill & Long, LLC to help us out. Here are the 5 most common tax planning mistakes they see real estate investors make:
Mistake #1: Not Understanding and Utilizing 1031 Exchanges.
A 1031 exchange, also known as a like-kind or tax-deferred exchange, is a way for an investor to sell a rental property, reinvest the proceeds in real estate and defer all (or some) of the capital gains taxes on the profit. While there are several rules concerning timing, participants and taxation, a successful 1031 exchange will result in potentially significant tax savings over time. In addition, when properly coordinated with estate planning, the use of a 1031 exchange may work to eliminate all future capital gains associated with the property (instead of simply delaying when the taxes would need to be paid).
Mistake #2: Not Understanding How Business Entities are Taxed.
The taxation of real estate rental income and capital gains can be calculated in many different ways, depending upon many different factors. These factors can include the choice of business entity (corporation versus personal versus LLC, etc.), the type of property (rental, investment, etc.) and your tax designation with respect to real estate (dealer, professional, investor, etc.). Do not make the mistake of setting up a business entity without first understanding the tax implications of using that type of entity with respect to your real estate venture.
Mistake #3: Not Understanding What is Tax Deductible/Lack of Records.
Most (hopefully all) real estate investors understand that the receipt of rental income and the sale of a parcel of real estate are potentially taxable events (and that taxes may be owed). However, what is missed on a very frequent basis are the records and information needed to produce the necessary tax deductions to offset as much of the taxable income as is legally possible. It is imperative that every investor have an accounting and recordkeeping system in place and obtain the necessary education on tax deductions. Of course, hiring a tax professional to assist with the preparation of the tax return(s) is usually highly recommended, as dealing with the federal and state tax laws is challenging (to say the least)!
Mistake #4: Not Understanding/Maximizing Depreciation.
All rental priorities are entitled to claim a tax deduction for depreciation. Depreciation is considered to be a tax deduction for the normal “wear and tear” of physical assets, including a building itself. What many real estate investors (and their tax professionals) fail to maximize is the amount of depreciation that can be utilized in any given year. A depreciation plan would include potentially utilizing component/cost-segregation depreciation, “bonus” depreciation, Section 179 expensing and other possibilities depending upon the current tax laws. Many real estate investors simply depreciate all property using the long 27.5 (residential) and 39 (commercial) year periods required for buildings.
Mistake #5: Doing Nothing.
Unless you have no income and have no plans for any future income, tax planning is critical to your overall financial success. With tax rates (in Colorado) at a potential 59.53% (39.6% federal income tax + 15.3% Self-Employment taxes + 4.63% Colorado income tax), it is imperative that a tax plan be established to legally reduce the amount of taxes that the laws require you to pay. Again, doing nothing is a sure way to make certain that the IRS and State Revenue Departments will win the tax game each and every year.
Did you find a mistake in your own tax plan? If you take nothing else from this remember: this is your money and a tax plan is required in order to keep as much of it as is possible.
Want to learn more about tax planning and preparation? Check out the ICOR February meetings in Denver, Loveland and Colorado Springs.
Tuesday, February 11th
Colorado Springs Monthly Meeting - Business Entities, Tax Planning and Asset Protection for the Real Estate Investors
Wednesday, February 12th
Denver Monthly Meeting - Business Entities, Tax Planning and Asset Protection for the Real Estate Investor
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Thursday, February 13th
Northern Colorado Monthly Meeting - Business Entities, Tax Planning and Asset Protection for Real Estate Investors