These are the most common mistakes that we encounter on tax returns related to real estate and rental properties. These aren’t just mistakes that people make when they’re doing their own taxes on TurboTax, these are the mistakes that are most common from returns prepared by tax professionals (CPAs and EAs). Even most professional tax preparers aren’t well versed in the correct way to prepare tax returns for real estate investments.
- Accidentally triggering major tax consequences. Major mistakes include things like spending too much time staying at your own rental property (above the personal use limits), renting a property at significantly below market rate (invalidating the deduction of expenses), putting a rental property into the wrong tax classification (such as a C corp or S corp), or passing a property to a relative as a gift rather than an inheritance. These actions can have major tax consequences. This is why talking to a real estate specialist tax advisor to review your situation is important.
- Not taking depreciation at all. It’s not uncommon for some CPAs or people preparing their own taxes to think that depreciation is optional. It’s not. What happens is depreciation has to be paid back when you sell a rental property, even if you didn’t claim the depreciation all the years you rented it out. So it ends up costing you a ton to pay back a benefit you didn’t actually receive. If you haven’t been claiming depreciation, there is a way to use form 3115 to claim past missed depreciation.
- Not depreciating the correct building value. We often see client returns where a CPA depreciated the entire purchase price of a property because they didn’t know they have to subtract out the land value (land is never depreciated!). And many use a “rule of thumb” like 20%/80%, which is a very common misconception, but it’s not allowed and can result in tax penalties in an IRS audit.
- Not including all the acquisition costs in the depreciation basis. Most tax preparers don’t know they can include realtor fees, lender fees, inspection fees, underwriting fees, and other costs as part of the depreciation basis. This won’t result in a penalty or fine, but it does mean you’re paying more taxes than you need to during the life of the rental property.
- Not amortizing mortgage points and lender fees. Some mortgage fees aren’t included in the depreciation basis, but are instead amortized over the term of the loan (most commonly 30 years). This will reduce the taxes on your rental a little bit each year, but when we look at returns from other tax preparers, it’s rare to see one where their previous preparer considered the mortgage points or lender fees.
- Not carrying forward passive losses. This most often happens when you switch from one tax preparer to another, and the new one fails to check your previous return for suspended passive losses that can be used to reduce your taxes in future years. You can check your past returns for a form 8582, and look for “unallowed loss” amounts in part VIII. Then check your next tax return and see if those unallowed losses were entered on the next year’s form 8582 part IV under the column labeled “prior years”. We’ve seen returns where clients had returns where a hundred thousand dollars or more of passive losses were not carried forward to future years. The IRS doesn’t notify you when this happens, it just gets lost if no one catches the mistake.
- Missing major expense deductions. We often see returns where they missed major rental expense deductions like mortgage interest, real estate taxes, or insurance. An experienced real estate tax professional should know to ask when any of the major expenses are unexpectedly missing.
- Missing minor expense deductions. There are also a lot of fringe expenses that are valid deductions that can reduce the taxes on your rental income. Some of the less commonly considered deductions include driving miles, home office deduction, and travel expenses.
- Putting short term rental income on Schedule C. There is a common misconception that short term rental income should go on schedule C. This is generally not correct, most short term rental income still goes on Schedule E.
- Not depreciating rental properties over 39 years. Long term (and medium term) rental buildings are depreciated over 27.5 years. But short term rental properties are depreciated as a different category that requires a 39 year depreciation schedule.
- Not taking advantage of advanced tax reduction options. For the right situation, strategies like cost segregation, the “short-term rental loophole”, real estate professional status, partial asset disposition, or using a 1031 exchange can save taxpayers thousands or hundreds of thousands of dollars on their taxes. Often taxpayers aren’t aware that these are options they can consider.
- Miscategorizing expenses for flippers. When flipping a property, the house and renovation costs have to be calculated as inventory costs, but often the expenses are written down as immediately deductible expenses, which is the incorrect tax treatment and can result in an expensive correction to make in a future audit situation.
- Not considering the consequences of interest tracing rules. Interest on a cash-out refinance, HELOC loan, or other real estate backed loan may or may not be used as a deductible expense depending on how the funds are used. This is often missed when tax pros think that interest from debt backed by real estate is automatically deductible as an expense against that property, but the interest tracing rules have to be used.
- Not considering “nonqualified use” for the section 121 home sale exclusion. Tax preparers are generally aware of the reduced capital gains taxes if you sell you your home that you lived in at least 2 of the past 5 years. But they’re often not aware of the “nonqualified use” rules that reduce the amount of the deduction if you lived in the home after a period of time when it wasn’t your primary residence.
- Not opting in to advantageous elections. There are elections such as the “De Minimis Safe Harbor” that can save money on your taxes and reduce the risk of penalties in an audit. In most situations there is no disadvantage to making these elections, and you can reduce your taxes and tax risks simply by opting-in on your return, but most tax preparers don’t know to add it.
As you can see, real estate investments and rental properties are an area where there are an exceptionally high number of common mistakes that most tax preparers make because they don’t know all the nuances of this part of the tax law. This is why it’s important to work with a tax professional that specializes in real estate investments.
