When you should hire a tax professional? Renting Real Estate

Most mistakes self-filers make in regard to their rental property often stem from a combination of misunderstanding the complexities of tax law, poor financial planning, and a lack of proactive management across several areas. Here are a few of those challenges and Independent Tax Advisors can help with most but not all of these relatively common mistakes.

1. Failure to Utilize Deductions (Depreciation, Repairs, and Losses)

• Mistake: Many landlords overlook critical tax-saving opportunities like depreciation. Depreciation can provide a significant reduction in taxable income, especially since rental property owners are allowed to depreciate the structure over 27.5 years (but not the land). A mistake in this area could cost thousands of dollars in missed deductions.
• Solution: Engage a tax professional to ensure you are properly accounting for depreciation, and avoid classifying repairs as capital improvements (which must be depreciated). Depreciation should be considered a part of your property management strategy, reducing your taxable income year after year.
  • Source: IRS Publication 946, How to Depreciate Property, emphasizes the importance of claiming depreciation for rental properties as an expense to reduce taxable income.

2. Poor Record Keeping and Tax Reporting

• Mistake: Mixing personal and rental property finances or using outdated record-keeping methods can complicate tax filings and lead to missed deductions. Not keeping clear and organized records of rental income, expenses, and repairs increases the likelihood of overpaying taxes and complicates your ability to substantiate deductions in case of an audit.
• Solution: Use property management software or maintain separate accounts for rental properties. Work with a tax professional to ensure your records are organized for maximum efficiency. Regularly reviewing your books throughout the year can help catch mistakes early.
  • Source: The IRS recommends using separate accounts for business and personal expenses to simplify tax reporting and avoid mistakes.

3. Misunderstanding Tax Classification (Repairs vs. Improvements)

• Mistake: Misclassifying repairs as capital improvements results in missed opportunities for immediate deductions. For instance, something like replacing a broken fridge is typically an expense that should be deducted in the year it occurs, not capitalized over time.
• Solution: Familiarize yourself with the IRS’s de minimis safe harbor rule, which allows landlords to deduct costs of items under $2,500 per invoice immediately. A tax professional can help you avoid mistakes in categorizing these costs.
  • Source: IRS Notice 2015-82 provides the de minimis safe harbor rule, which allows landlords to deduct smaller property expenditures in the year incurred instead of capitalizing them.

4. Ignoring Passive Loss Rules and Form 3115

• Mistake: Failing to file IRS Form 3115 when passive losses or other accounting methods need to be changed can lead to tax compliance issues and penalties. Many landlords overlook the need for this form when adjusting depreciation or passive loss deductions.
• Solution: When passive losses exceed rental income or changes in depreciation methods are required, consult a tax professional to file Form 3115 properly and avoid costly penalties or missed opportunities for tax relief.
  • Source: IRS Form 3115 allows for the change of accounting methods, which can be crucial in ensuring compliance with the tax code when changes occur.

5. Liability Exposure and LLC Structuring

• Mistake: Failing to form an LLC leaves personal assets vulnerable to lawsuits. Even a small number of properties expose landlords to liability risks, especially in areas with stringent tenant laws or where accidents could occur on the property.
• Solution: Form an LLC to limit personal liability. Although there are costs involved in maintaining an LLC, this step could protect you from the financial consequences of tenant lawsuits, property damage claims, or business-related issues.
  • Source: IRS guidance confirms that LLCs can be beneficial in protecting personal assets from liability while also offering some tax advantages.

6. Financial Mismanagement and Over-Leveraging

• Mistake: Over-leveraging properties by taking on excessive debt can create cash flow problems and jeopardize the financial stability of your rental business. It’s important to consider all costs associated with owning rental property, such as maintenance, insurance, property taxes, and management fees, when assessing financing options.
• Solution: Plan for steady cash flow by maintaining adequate reserves for emergencies and vacancies. Use financial models and engage a tax professional to help structure your loans and investments so you’re not overexposed in tough financial times.
  • Source: The Federal Reserve has noted that over-leveraging increases risk during periods of economic downturns, which can harm landlords’ financial stability (Federal Reserve).

7. Insurance and Risk Management Oversights

• Mistake: Insufficient or inadequate insurance coverage can leave landlords exposed to financial disaster in the event of property damage or tenant-caused losses.
• Solution: Obtain comprehensive landlord insurance, including liability protection and coverage for loss of rental income. Additionally, require tenants to have renters’ insurance to protect both parties in case of an emergency.
  • Source: The Insurance Information Institute (III) stresses the need for comprehensive insurance policies, including liability and loss of rental income protection for landlords.

8. Failing to Keep Up with Legal Requirements and Tax Changes

• Mistake: Not staying updated on local tax laws, zoning regulations, or landlord-tenant laws can lead to legal violations or missed tax-saving opportunities. A simple mistake in complying with local codes can lead to fines or other complications.
• Solution: Consult with professionals who can help you stay compliant with legal and tax requirements. Regularly review changes in tax law and property regulations to ensure you’re not falling behind.
  • Source: HUD’s Fair Housing regulations and local city or state websites will keep landlords informed on evolving laws affecting tenants and rental businesses (HUD).

Navigating the complexities of rental property ownership from a tax perspective requires careful planning and attention to detail. By addressing the common mistakes across multiple disciplines—taxation, property management, legal compliance, and financial planning—landlords can better position themselves for long-term success. Engaging a tax professional is helpful to ensure you’re utilizing all available tax benefits, properly categorizing expenses, and avoiding costly mistakes that could reduce your rental income or expose you to unnecessary risk.