Here is the standard answer to all legal and tax questions: it depends. In this case, it really does. We have to start by answering 3 critical questions:
- What kind of real estate business?
- Did it actually start in 2021?
- What type of expenses?
Two types of real estate businesses.
Unfortunately, the IRS does not recognize “real estate investor” as a type of business. They have no rules and no forms for realty investors in general, only for two specific and distinct groups of investors:
- Landlords who own properties and rent them out (buy-and-hold investors) and
- Resellers, aka dealers, of real estate (buy-and-flip investors and wholesalers)
You can be one, the other, or both. If you have both rental and flip properties – then, according to the IRS, you run not one but two separate businesses. The distinction is extremely important, because these two types of businesses are taxed under very different rules.
Landlords earn what the IRS calls “passive income”, and it is reported on Schedule E. If the total collected rent is higher than landlord’s expenses, he pays income tax on the difference. Landlords do not pay Social Security or Medicare taxes. If a landlord has more expenses than the rent he collects, he has a “net loss” which may be deductible or may be restricted.
Resellers earn “business income” which is reported on Schedule C. If there is a net profit after deducting business expenses, the reseller pays income tax plus Social Security/Medicare taxes. If there is a net loss – it is usually deductible without limitations.
As you can see, there is a huge difference between the two, and I only mentioned the most fundamental rules. There’s much more to this, of course. So, when you say that you started your real estate business in 2021, you must clarify: did you start
A. a rental business
B. a rehabbing/wholesaling business or
C. both of them
Did it actually start in 2021?
This question may sound stupid, but it is not. Staring to spend money does not automatically mean starting a business, not for the IRS anyway. As you probably expect, the IRS defines “starting” very differently for the two types of real estate businesses.
For rehabbers and wholesalers, you start your business when you first make an attempt to buy a deal. To announce your “grand opening”, you don’t have to wait until you actually close on your first deal, but you do have to start actively looking for deals and be ready to pull the trigger. If all you did in 2021 was take classes – then you have not started yet.
For landlords, it is tougher. Not only do you have to start looking, but you must purchase your first property before you are considered “in business” by the IRS. It should make sense if you think about it: how can you be in the business of leasing properties before you have any properties to lease? In other words, if you did not have any rentals on December 31st, then you have not started in 2021.
In fact, the landlords’ rules are even more restrictive. Simply buying a future rental is not enough. The property must be ready and available for rent – which is another way to say that the initial rehab must be finished. If you bought a fixer-upper in December, and you were in the middle of construction on New Year’s Eve, then the property was not ready in 2021, and you cannot claim that your rental business started in 2021. Sorry.
What type of expenses?
Suppose we got past the first two questions and determined that yes, the business did start in 2021. What’s next? Next is sorting out various expenses.
Regular operating expenses.
These are the usual expenses such as marketing, supplies, technology, legal and accounting, insurance, driving, and so on. While certain specific types of operational expenses – such as automobile or business meals – have their own complications, the general rule is: they are deductible once the business has started.
Acquisition costs.
Buying the property itself is never a deductible cost. If you bought a flip property, you record but do not deduct the purchase costs. You will deduct them against the sale price of the property once it is sold. For example, if the property was bought last November and sold in January – it will be reported next year, on your 2022 tax return, the year of sale. On that return, you will take the 2022 sale price and subtract the 2021 purchase costs.
Buying a rental property requires you to calculate its total purchase cost and then deduct it in small portions over many years: 27.5 years for residential properties and 39 for commercial. This method is called depreciation, and it is a very complicated concept. Even professional tax preparers mess up depreciation if they are not real estate specialists. Beware.
Repairs.
This is a highly controversial topic. Real estate investors love the word repairs. We call a $200 sheetrock job a repair, and we also talk how a certain wholesale deal needs “$50k in repairs.”
Unfortunately, the IRS does not see it this way. Most substantial construction projects, especially the initial rehab, do not meet the IRS definition of repairs. Instead, they are classified as capital improvements and have to be deducted over many years via depreciation. Yes, I know it does not sound fair. But we’re talking taxes, not fairness. An entirely different game.
Big ticket items, aka assets.
If an item costs substantial money (whatever this means) and will serve you for more than one year – it is an asset. Examples: computers, iPhones, appliances, trucks, equipment, and so on. By the way, carpet and floating laminate flooring are also assets. Assets are not deducted, they are depreciated. As I already warned you, depreciation is complicated, and you may need help if you’re new to it.
Education.
Training costs deserve a special discussion because they are often large, and because they are very common for new investors. Inexpensive classes taken after your business started are easily deductible as operating expenses – no problem there.
The problem is how to treat a $25k mentoring or membership program paid before you buy your first deal. Most of the time, it should be treated as start-up costs, explained below. Sometimes, it can be treated as a depreciable asset. Discuss it with an accountant who understands real estate.
Start-up costs.
Those are all costs incurred before the business started: education, research, legal, building a website, etc. Again, the treatment is different for each of the two types of REI businesses. Rehabbers will report these costs as start-up expenses once the business goes live. This allows you to deduct $5k right away, and the rest of it over 15 years. Landlords are supposed to roll all those costs into the acquisition costs of their first rental property – which results in these costs being depreciated.
Clearly, this is not what you want, but this is what the IRS wants. As always, there is room for interpretation and creativity. A good accountant who specializes in real estate can save you a lot of money and prevent a lot of problems. Get one of us on your team.