Tax Deductions: The Best, the Worst, the Trickiest

The Best Tax Deductions

The best tax deductions are those that do not require cash outlay, yet generate tax savings for you while the property is still generating a positive cash flow and appreciating.

“Component” depreciation puts a lot more cash in your pocket.

A prime example is rental property depreciation, which is a “paper” deduction you take with no cash outlay, yet it creates cash in your pocket via the tax savings from the deduction. For example, a $3,000 depreciation deduction saves you $900 in a 30% tax bracket.

Even better is Component Depreciation (or cost segregation analysis), which is breaking out the property’s cost into depreciable components with shorter recovery lives. This equates to significantly higher depreciation deductions and savings.

In the above example, if you used component depreciation, the deduction would be $10,000 (instead of $3,000) with a savings of $3,000 (instead of $900) or a big difference of $2,100 cash in your pocket.

Second Best Deductions

The second best tax deductions are expenses you have being paying anyway but not deducting because you did not know how to, were not advised to, or wrongfully told you can’t.
One example is paying your children or other family members a deductible pay instead of a non-deducible allowance to assist you in your business. Other examples are travel, meals, entertainment, auto–all documented as business expenses.

Better Than Tax Deductions – Tax Credits

Even better than tax deductions are tax credits. Tax credits reduce your taxes dollar-for-dollar, whereas a tax deduction reduces your taxes according to the income bracket you’re in. Example: A $10,000 tax deduction in a 30% bracket reduces your taxes by $3,000, which is great. But a $10,000 credit reduces your taxes by $10,000, which is greater!
Examples of huge money-saving credits are low-income housing credits, credits for handicap improvements, and rehab credits for improvements to older commercial properties or historic rental properties.  Plus, such improvements can dramatically increase the cash flow and value of the property.

A Perfect Example

Years ago, I remember a lady who owned an apartment building in a desirable area. It was a stately looking property with definite historic character. However, it had a tacky name (like “The Sanford Arms”) and needed a lot of rehab to restore the property to its original historic splendor.

She learned about the rehab credits from her own research, not her CPA. So she did the necessary qualifying improvements of $100,000 to upgrade the property and qualify for the 20% rehab credit. She also changed the name to “Apartments Of Distinction”.

Result: She more than doubled her rents which substantially increased the property’s cash flow and value. Plus, she ended up with $20,000 of tax credits in her pocket.  She made more money from the property and from the IRS!

The sad thing is that most real estate investors do not take advantage of these credits (and their immense value) because most CPAs simply don’t know about them.

The Worst Deductions

The worst tax deductions are those with significant audit risk, such as deductions taken on highly audited IRS schedules, especially deductions for travel, entertainment, auto, and real estate education, especially with little or no income on the IRS Schedule.
Such deductions should be well-documented and claimed on a properly structured LLC-partnership.

The Trickiest Deduction – Interest!

Deducting interest is neither automatic nor simple. Under complex rules, the tax treatment of interest can range from fully deductible to partially deductible to not deductible at all. The general rule of whether interest will be deductible or not depends on how the funds are used, not the security for the loan.
For example, you refinance your rental property and use the loan proceeds to take a personal trip around the world. Even though the security for the loan was a rental property, none of the interest is deductible because you used the loan funds for personal reasons.
On the other hand, if you used the funds to purchase rental property or for a business, the interest would be deductible.
An exception to this general rule, regardless of how the funds are used, is on a home equity loan up to $100,000. Here the interest is deductible on Schedule A (Form 1040), Itemized Deductions  (unless you make a special IRS election, you can instead deduct the interest on a business schedule like partnership Form 1065, which is generally better).
So to fully deduct interest, you need to know the rules and plan accordingly.

Deducting Real Estate Education – Yes or No?

Here is a question I frequently get from my students, “Al, my CPA says I cannot deduct my real estate education because I only own one rental property and therefore am not in a business. Is this true?”
You know the power of education, so you astutely attend real estate conferences, boot camps, invest in home study courses and coaching programs. The cost can add up.  Naturally, you want to deduct the education (and any related travel), so the tax savings can offset the costs.
But many CPAs will say – NO deduction,  even if you own investment property, or especially if you do not yet own any properties.  Why?
One reason is that many CPAs are just plain overly conservative and only will allow obvious “safe” deductions, such as real estate taxes and rental property insurance.
Another reason is that many take the position that real estate is an “investment” and not a “business.” We know it’s really both. Education deductions for “investments” (such as stocks) are very limited, but for a “business” they are not.  So from a tax viewpoint, is real estate an “investment” or a “business”?
Most tax law authority states that it is a business, even one rental property. But such tax law authority requires you essentially to do eight things to document your real estate as a business. Here are three of them:

  • Run it like a business (having a business plan helps).
  • Keep good business records
  • Use an LLC entity, especially if you are a beginner

The above are excerpts from Al Aiello’s tax system The Renaissance Goldmine Of Brilliant Tax Strategies for Real Estate Investors. 

By Al Aiello, CPA, MS Taxation

For decades, Al Aiello has been a national leader in strategies for protecting wealth. His Renaissance Goldmine of Brilliant Tax Strategies helps Real Estate investors maximize their deductions to minimize their tax payments.