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I am looking for an answer from a CPA who specializes in real esate.
I qualify as a real estate professional, Sec. 469(c)(7)(B)
I have income from real-state profession form-1099 which is shown in Schedule-C
I have other income and loses from three rental properties. Two are positive and 3rd one is negative. This 3rd one I bought in a short-sale and the whole last year there was no income from this 3rd unit we have loses as we have renovate bath/kitchen etc (like capital improvements).
The questions are related to my taxes:
How to deduct first time capital improvements? Do they go into Schedule-E ? Or Can I deduct in Schedule-C from my other active real-estate professional income from 1099?
Can I deduct all 37K loses in Schedule-C or do I have to extended deductions over 15 or 27.5 years?
Advantage or disadvantage to group all properties into one (please refer below notes)Notes below:
“Under Sec. 469(c)(7)(A), each interest of the taxpayer in rental real estate is treated as a separate activity for purposes of determining whether the taxpayer materially participates in the rental real estate activity, unless the taxpayer, in a year in which the taxpayer qualifies as a real estate professional, elects under Regs. Sec. 1.469-9(g) (the grouping election) to treat all interests in rental real estate as a single rental real estate activity for the material participation tests of Temp. Regs. Sec. 1.469-5T. The grouping election applies to the current tax year and all future tax years, even if there are intervening tax years in which the taxpayer is not a real estate professional.”
Submitted: 8 months ago.Category: Tax
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9/17/2017
Tax Professional: emc011075, Tax adviser replied 8 months ago
emc011075
emc011075, Tax adviser
Category: Tax
Satisfied Customers: 3,697
Experience: IRS licensed Enrolled Agent and tax instructor
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Hi. My name is ***** ***** I will be happy to help you.

Being a RE professional does not change the origin/nature of the income. All income and expenses related to renting a space to a tenant is reported on Schedule E unless you also provide additional service like room service, housekeeping, laundry services and such. If you run a vacation rental (cottages or rooms), B&B or small hotel you would report it on Schedule C.

Income reported on 1099Misc as nonemployee compensation goes on Schedule C, income reported as Rent goes on schedule E.

All capital improvements must be depreciated. If you bought a property that needed some work before it could be rented, you will add the pre-renting improvements to your basis for depreciation (along with the purchase price and administrative/transfer fees) and depreciated over 27.5 years. Unfortunately you cannot use sec 179 (first year write off) for a rental property.

Regarding the election, grouping will allow you to deduct losses from rental properties that would be otherwise disallowed. With an election you will need to treat every rental property as separate activity to determine if you meet RE professional test. If you elect to group them than you can treat all properties as one activity.

However, if you have any prior year disallowed losses and you group the property that carries these loses, you will not be able to deduct the losses until you sell/dispose the entire group.

So, before you decide to group the properties consider how much disallowed losses you have and if you plan to sell these properties anytime soon.

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Customer reply replied 8 months ago
Hello Eva,
Thank you for quick reply. This is where confusion is there. Please read the following and you may change your answer. There is main advantage for real-estate professional for taking loses (instead of amortization done by non-real-estate professionals)http://www.auburnmainecpa.com/taxes-for-real-estate-professionals/
from the above link :-- “If a taxpayer is considered to be a real estate professional, then the limitation on deducting rental losses does not apply to them, and they can deduct the losses from a rental property without being concerned about the passive lost rules”https://www.irs.gov/pub/irs-utl/33-Real%20Estate%20Professionals.pdf
from the above link Example of Laura”http://www.ustaxcourt.gov/InOpHistoric/Agarwal.SUM.WPD.pdf
form the above link – please read “page -10)
http://www.nolo.com/legal-encyclopedia/tax-advantages-landlords-married-real-estate-professionals.html
from the above link :-- “Example: Dr. Jones is a busy single physician who also owns two dozen rental units, that incur losses of $50,000 each year. He can’t deduct any of these losses from the $250,000 he earns each year from his medical practice. The good doctor marries Joan, a real estate agent. She manages the rental units and continues to work at her agent business part-time. She qualifies as a real estate professional and spends sufficient time managing the rental properties so that they are exempt from the passive loss rules. When Dr. Jones and Joan file their joint return, they can deduct their $50,000 loss from Dr. Jones’ other income. They save $17,500 in federal income tax. What a great basis for a successful marriage!”http://www.cpabythebay.com/blog/rental-real-estate-as-an-investment/425
from the above link :--“ (2) Real Estate Professional Exception - If you qualify as a “real estate professional” (which requires the performance of substantial services in real property trades or businesses), your rental real estate activities are not automatically treated as passive, and so losses from those activities can be deducted against earned income, interest, dividends, etc., if you materially participate in the activities. “https://www.biggerpockets.com/renewsblog/2014/09/25/your-complete-guide-to-the-real-estate-professional-tax-loophole/
from the above link :-- “For someone who is a real estate professional if they have a total income of $200k and net rental losses of $50k, this means that they can use $50k of losses to bring down their total taxable income to $150k. On the other hand, if this taxpayer was not a real estate professional, then their taxable income would remain at $200k for the year”Thank you
CC
Tax Professional: emc011075, Tax adviser replied 8 months ago

I did not say that you cannot deduct the losses. Reporting the rental activity Schedule E does not automatically makes the income/losses passive.

From the IRS publication 925:

If you qualified as a real estate professional for 2016, report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses, and complete line 43 of Schedule E (Form 1040).

It is not the form used (schedule C or E) that determines if the loss is treated as active or passive.

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Customer reply replied 8 months ago
Hello Eva, thanks for reply.
You said "All capital improvements must be depreciated. If you bought a property that needed some work before it could be rented, you will add the pre-renting improvements to your basis for depreciation (along with the purchase price and administrative/transfer fees) and depreciated over 27.5 years. Unfortunately you cannot use sec 179 (first year write off) for a rental property."
I do not want to depreciate over 27.5 year.
I just want to take those losses (even capital improvements) in this year. That is what the above links explain, Am I allowed to take write off the losses in this year instead of depreciating over several years? Am I wrong ? This is where I am seeking an answer.
Thank you
CC
Tax Professional: emc011075, Tax adviser replied 8 months ago

Ok. Do not confuse loses and expenses. A loss is the difference between rental income and rental expenses. There are set rules how rental expenses can be deducted TO CALCULATE PROFIT OR LOSS. All of the links are talking about loses (income - expenses). You are allowed to take all your losses as long as you follow the deduction rules, including depreciation rules. Qualifying as RE professional allows you to claim all the losses but it does not change the rules how to calculate them. All capital expenses must be depreciated. All pre-rental expenses must be added to the basis for depreciation. Rental expenses and real property (buildings) do not qualify for sec 179 depreciation. You can only use sec 179 for Schedule C (business) asset. As long as you follow these rules to calculate your loses, you can deduct them. You can do what you want with the product (losses) but you cannot change how it is made (income and expenses reporting rules).

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Tax Professional: emc011075, Tax adviser replied 8 months ago

Does it make sense? Passive activity loss limitations (exceptions) apply to the losses generated by the activity (rental, business), not the individual expenses.

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Customer reply replied 8 months ago
Hello Eva, I am more confused now. All the links above (about loses) clearly say, I can deduct them in the current year's return.
Even the court case (in one of the above link) says I can deduct in the current year instead of 27.5 years.
If real estate professional can deduct over 27.5 years, then there is no difference from a non-real estate professional. They too can deduct the loses over 27.5 years.
Below link from a CPA, clearly says, I can deduct all the loses right away against earned income etc.
http://www.cpabythebay.com/blo…
from the above link :--“ (2) Real Estate Professional Exception - If you qualify as a “real estate professional” (which requires the performance of substantial services in real property trades or businesses), your rental real estate activities are not automatically treated as passive, and so losses from those activities can be deducted against earned income, interest, dividends, etc., if you materially participate in the activities. “
Tax Professional: emc011075, Tax adviser replied 8 months ago

Correct. You CAN deduct the LOSSES. But an expense or depreciation IS NOT A LOSS. A purchase price is not a loss, capital improvement is not a loss. You can use the expenses (purchase price, improvements) to TO FIGURE OUT YOUR PROFIT OR LOSS.

None of the articles say that the passive activity rules applies to expenses. A loss is a final product, income and expenses is the raw material the product is made of. You can deduct the final product but you cannot choose how it is made.

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Customer reply replied 8 months ago
It is NOT a passive activity anymore for real estate professional.
" Real Estate Professional Exception - If you qualify as a “real estate professional” (which requires the performance of substantial services in real property trades or businesses), your rental real estate activities are not automatically treated as passive, and so losses from those activities can be deducted against earned income, interest, dividends, etc., if you materially participate in the activities. "Income = 0
Expenses (capital improvements)+other = $ 40000
Total Income or Loss = -$40000
Expenses means all expenses including capital improvements. They did not differentiate real estate professional cannot deduct.
You want to say , if they are not capital expenses, then I can take $40000 deduction in the current year?
Thanks
Tax Professional: emc011075, Tax adviser replied 8 months ago

You start with your income. You deduct all your operational expenses. You deduct your allowable depreciation (regular, bonus, sec 179 - whatever you are allowed to take according to depreciation rules). You deduct your business use of home if any and vehicle expenses, if any to arrive at profit or loss.

If you are RE professional than you can deduct all your LOSSES. However, you have still to follow depreciation rules. Capital improvements cannot be deducted, they must be depreciated. A depreciation is an expense not a loss. RE professionals can deduct all of their losses but they are not immune to depreciation rules.

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Tax Professional: emc011075, Tax adviser replied 8 months ago

Section 162 of the Internal Revenue Code (IRC) allows you to deduct all the ordinary and necessary expenses you incur during the taxable year in carrying on your trade or business, including the costs of certain materials, supplies, repairs, and maintenance. However, section 263(a) of the IRC requires you to capitalize the costs of acquiring, producing, and improving tangible property, regardless of the size or the cost incurred.

You cannot deduct capital improvements, you must depreciate it and you cannot use sec 179 (first year write off) for real estate or rental property.

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Tax Professional: emc011075, Tax adviser replied 8 months ago

I believe that the confusion is created by misunderstanding what RE professional really is. A RE professional is a business person who is actively involved in real estate and for tax purposes is treated as such. He is treated as any other business owner. Business owners actively participating in their business cannot ignore income or deduction rules (including depreciation) just because they actively participating in the business operation. Business owners can deduct their loses without restriction but they cannot just expense everything. There are limits on capital expenditures, meal and entertainment expenses, vehicle expenses and certain job related education expenses. The same apply to RE professionals. Being RE professional allows you to deduct your losses but it does not allow you to ignore or disregard any other tax rules, including how you treat your capital expenses or improvements.

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Customer reply replied 8 months ago
Thank you for clarifying these issues. I do not know how investors who buy short sale, foreclosure properties and spend upfront money to fix can deduct in the first year. Lot of money gets stuck and I will think twice before I buy these fixer uppers.Appreciate your answers.
-CC
Tax Professional: emc011075, Tax adviser replied 8 months ago

You're welcome.

When you buy a house for an investment you have three options.

You rent it, in which case the house itself is used to generate income (reported on Schedule E as rental income). You can buy and hold it for investment purposes and sell it when the house increase in value (reported on Schedule D as capital gain or loss). You generally invest in upkeep but no major improvements. In this case the house is your investment property and you cannot deduct any depreciation or your investment until you sell the house.

Or you can buy, flip and sell it within few month. In this case the house will be your inventory and you can deduct all the operational expenses. When you sell it you will deduct the purchase price and cost of improvements as cost of goods sold and upkeep and maintenance as operating expenses (reported on Schedule C as profit or loss from business). But you cannot deduct the purchase price until you sell the house and you cannot depreciate it either.

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Customer reply replied 8 months ago
What is the 3rd option? In my case , I bought a short sale property and spent about 40K in renovating. After renovating for 9 months, we wanted to keep it as rental. That is where I made a mistake. I should have just flipped it in the last year. Now it is already rented. Thank you.
Tax Professional: emc011075, Tax adviser replied 8 months ago

You can still sell it after one year. You will not have much depreciation and the loss will be treated as ordinary loss. Ordinary loss, unlike capital loss is not limited by 3K per year. But in order to treat the loss as ordinary, you will have to rent it for at least one year (a rule of the thumb), otherwise the IRS will disallow the loss and treat it as capital loss.

After the real estate crash few years ago many people "converted" their homes into rentals for few month or "rented" it to relatives to claim business loss since loss on sale of personal residence is not deductible. More often than not the IRS disallowed the losses unless the property was rental property for at least 12 month and rented for fair market value to an unrelated party.

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