A Good Accountant, a Real Estate Investor's Ally
Q: I own a four-unit rental building and am trying to understand the tax rules so that I can prepare my tax return. I would prefer to use one of the tax services on the Internet, rather than pay for an accountant. Can you provide me with the basics?
A: Yes, but I still recommend that you retain a professional accountant to assist you. While many of the Internet services are adequate, there still is nothing better than having a real live person to talk to -- and to hold accountable should mistakes be made. And besides, the accountant's fee is tax deductible.
A lot of people in the Washington area own investment real estate, and this includes single-family houses and condominium or cooperative apartments, as well as large office complexes and shopping centers.
Many people are investors by choice; they believe that real estate is a good investment. Others are investors by default; they could not sell their family home when leaving this area, and decided to become landlords instead.
Before Congress dramatically changed the tax laws in 1986, real estate investment was usually considered a "profit making activity" for tax purposes. Deals could be structured in a way that provided rental income but still generated paper losses that translated into large tax shelters.
In addition to deducting your actual out-of-pocket expenses from rental income -- such as mortgage interest payments, real estate taxes, leasing commissions, advertising and repairs -- the law also allowed you to take a paper loss called depreciation.
For example, back then, if you bought a piece of property for $200,000 and the land value was appraised at $95,000, the depreciable basis for the building was $105,000. (Land cannot be depreciated for tax purposes.) The tax laws then allowed you to take accelerated depreciation, and take a large paper loss each year. Indeed, if you decided to elect straight line depreciation, depending on what year you were in, you might have the option to depreciate the property on a basis of 18 or 19 years. Assuming that you selected an 18-year basis, you could take a paper loss of $5,833 each year on your tax return ($105,000 divided by 18).
Congress and the Reagan administration were concerned about the growth of the tax shelter industry. Often, promoters and speculators would buy property that would not necessarily be a good investment, but would generate a significant tax write-off every year.
When Congress enacted the Tax Reform Act of 1986, it created a new concept called "passive activities." Although the primary reason for the creation of passive activity was to curtail tax shelter abuse, the result was a dramatic impact on the average real estate investor.
Passive activity regulations are complex. Here is a very brief summary of passive activities as they relate to real estate transactions.
For all practical purposes, most investment real estate transactions fall into the category of passive activity. Oversimplified, this means that real estate losses may only be used to offset income from other real estate activities.
Prior to the 1986 Tax Reform Act, you were able to deduct your real estate losses from other income sources, such as wages and stock dividends. However, beginning in 1987, this situation changed.