Depreciation of Real Estate

When you own rental property, depreciation is your best friend.

One reason depreciation is so valuable is that, unlike deductible rental property expenses such as interest and maintenance, in which hard earned dollars have to leave your wallet. Depreciation allows you to claim expenses (in the form of depreciation) year after year without having to pay anything beyond your original investment in the property.

In addition, rental property owners (commercial and residential) are entitled to depreciation even if their property goes up in value over time (as it usually does).

The basic idea behind depreciation is simple, however the practical application (especially in reporting it on your taxes) can become quite complex.

For example, if you own a motel with a depreciable basis of $1 million, you get to deduct $25,640 each year for depreciation (except the first and last years). If you own an apartment building with a $1 million basis, your depreciation deduction is $36,360.

Why the difference? A motel and apartment building are both rental real estate. Shouldn’t they be depreciated the same way? Not according to the tax law. An apartment building is a residential rental property, while a motel is a commercial rental property. There are different depreciation periods for commercial and residential property: it takes far longer to depreciate commercial property fully.

For this reason, you should always make sure you correctly classify your property as commercial or residential. Such classification can be more challenging than you might think, especially for mixed-use property. If you rent to residential and commercial tenants, the tax code classifies the building as residential only if 80 percent or more of the gross annual rent is from renting dwelling units.

Even properties rented only for residential use may have to be classified as commercial if a majority of the tenants or guests are transients who stay only a short time. This rule can adversely impact the depreciation deductions for property owners who rent their property to short-term guests through Airbnb and other short-term rental platforms.

If you’ve been using the wrong depreciation period for your residential or commercial rental property, you should correct the error by filing an amended return or IRS Form 3115 to fix depreciation errors that are more than two years old.

Melissa Broughton is the Co-Owner of Busy Bee Advisors a Sacramento based Bookkeeping, Tax & Accounting firm. For more information on the services offered please visit their website at www.BusyBeeAdvisors.com

Having Your Cake & Eating It Too…The Best Of Both Worlds. Using A Vacation Home As Rental Property & For Personal Use

Chances are if you have a second home (one that may have been inherited or purchased with the best of intentions) you’ve considered the extra income stream with services like AirBnb or VRBO.

Not too long ago if you had a second home that was in a desirable location you would need to enlist the services of a property management company to rent out your property. Now with companies such as AirBnb and VRBO (just to name a few) you can turn the extra room in your house into some extra cash. However here are some items to consider before taking the jump.

When you use a home for both rental and personal use, regardless of that home’s location at the beach or in the city, you run into the tax code’s vacation home rules that make that home either a residence or a rental property.

It’s a residence when you;

  • Rent it for more than 14 days during the year
  • Use it for personal purposes for more than 14 days
  • 10 percent of the days that you rent the home out at fair market rates.

Example. You own a beachfront vacation condo. During the year, you rent it out for 180 days. You and members of your family stay there for 90 days. The property is vacant the rest of the year except for seven days at the beginning of winter and seven days at the beginning of summer, which you spend maintaining the property. Your condo falls into the tax code–defined personal residence because

  • You rented it out for 180 days, which is more than 14 days, and
  • You had 90 days of personal use, which is more than 14 days and more than 10 percent of the rental days.

Disregard the 14 days you spent maintaining the place.

The key principle that applies when your vacation home is a personal residence is that expenses other than mortgage interest and property taxes allocable to the rental use cannot exceed the gross rental income from the property. In other words, rental operating expenses and depreciation cannot cause a tax loss on Schedule E of your Form 1040 for the year in question.

If you need assistance on how your ‘vacation home’ can be considered a ‘vacation home’ or investment and not a personal residence our team of tax advisors is happy to help. Reach out to us at info@busybeeadvisors.com and we’d be happy to assist.

Is It A Business Or Is It A Hobby?

Are you a part of the growing gig economy? Do you run a side hustle? Wondering if it’s a business or a hobby? Are you reading this and wondering why you should care?

For the purpose of taxes these activities are more commonly referred sideline activities. Think Direct Sellers (i.e. Tupperware, Mary Kay, Pampered Chef, etc) or Uber and Doordash.

The tax benefits of being able to write off expenses for these endeavors can reap tremendous rewards.

To begin ask yourself this; From this sideline activity, are you claiming tax losses on your Form 1040? Will the IRS consider your sideline a business and allow your loss deductions or is it simply a hobby?

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. The federal income tax rules for hobbies have been anti-taxpayer for years, and now an unfavorable change enacted in the Tax Cuts and Jobs Act (TCJA) made things even worse for 2018-2025.

Here’s the test:

If you can show a profit motive for your now-money-losing sideline activity, you can classify that activity as a business for tax purposes and deduct the losses. Are you doing it to make money?

Consider this;

  • Record Keeping is Key: Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies. (Did anyone say bookkeeping?!?)
  • Constantly Learning: Having expertise in the activity or hiring advisors who do. (Sideline activities provide an excellent reason to reinvest in yourself by researching, reading and attending seminars to not only re-energize you but to increase your knowledge base)
  • Time Spent: By spending enough time to justify the notion that the activity is a business and not just a hobby. (This is especially important for Real Estate Agents who must meet the annual 750 hour minimum)
  • Will your initial investment produce positive returns….eventually: Expectation of asset appreciation: this is why the IRS will almost never claim that owning rental real estate is a hobby, even when tax losses are incurred year after year.
  • Success in other ventures, which indicates that you have business acumen.
  • The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or just plain bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
  • Your financial status: Wealthy individuals may be able to afford ongoing losses (which may indicate a hobby), while ordinary individuals are usually trying to make a buck (which indicates a business).
  • Elements of personal enjoyment: breeding racehorses is lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.

Remember the key component is in the intention, can you (if questioned) prove that your intention was to make a profit?

A Word About Self-Directed IRAs

Tax-advantaged retirement accounts such as IRAs are a great way to save for retirement.

But when you establish a traditional IRA with a bank, a brokerage, or a trust company, you are ordinarily limited to a narrow range of investment options, such as CDs and publicly traded stocks, bonds, mutual funds, and ETFs. Many IRA custodians will not permit you to invest in alternative investments such as real estate, precious metals, or cryptocurrency.

A self-directed IRA could be for you if you want to walk on the wild side and invest your retirement money in assets such as real estate, small business ventures or cryptocurrency.

In fact the investment options are almost endless.

Here is what you can NOT use your self-directed IRA to invest in; (the list is short)

  • Collectibles (such as art or rare coins)
  • Life insurance
  • S corporation stock

Here is what you CAN use your self-directed IRA to invest in; (but are not limited to, the following):

  • Real estate
  • Private businesses
  • Trust deeds and mortgages
  • Tax liens
  • Precious metals such as gold, silver, or platinum
  • Private offerings
  • LLCs and limited partnerships
  • REITs
  • Livestock
  • Oil and gas interests
  • Franchises
  • Hedge funds
  • Cryptocurrency

Promissory notesAside from the vast array of investment options, a self-directed IRA is the same as a traditional IRA and subject to the same rules. The income the investments in your IRA earn is not taxed until you take distributions, but distributions before age 59 1/2 are subject to a 10 percent penalty unless an exception applies.

You can also have a self-directed Roth IRA for which distributions are tax-free after five years.

But you must avoid self-dealing and other prohibited transactions, or your self-directed IRA could lose its tax-advantaged status.

Establishing a self-directed IRA need not be too difficult. You first open an account with a custodian that offers self-directed investments. You can also acquire checkbook control over your self-directed IRA by forming a limited liability company to own all the IRA investments.

Please note investing in alternative assets such as cryptocurrency is riskier than stocks, bonds, and mutual funds.

  • The rewards can be great, as you’ve seen with recent returns for cryptocurrency investors.
  • And the damage to your investment portfolio can be substantial, as we’ve also seen over the years.

When it comes to alternative investments, you need to know what you are doing or have an investment professional you trust to do this for you. Busy Bee Advisors has access to several well-respected companies that can educate and assist you. Please reach out to us at info@busybeeadvisors.com if you would like more information or if you would like us to make an introduction.

2021 Tax Credits to Know

For tax year 2021, Congress is giving away billions of dollars in additional tax credits on your Form 1040 individual tax return.

These temporarily expanded tax credits include the child tax credit, the dependent care credit, and the health insurance premium tax credit.

With good planning on your end—which, if you are a small business owner you have more control over than most do because you are in business for yourself—the various credits could easily put an additional $5,000 or more in your pocket for tax year 2021.

Child Tax Credit—Current Law

In tax year 2020, you received a $2,000 tax credit for qualifying children who had not reached age 17 by the end of the tax year. Up to $1,400 of the credit was refundable if you had earned income and had no overall tax liability.

If your modified adjusted gross income (MAGI) exceeded $200,000, or $400,000 on a married-filing-jointly return, then your 2020 credit decreased by $50 for each $1,000 (or fraction thereof) your MAGI was over the threshold.

Child Tax Credit—Tax Year 2021

For tax year 2021 only, the child tax credit amounts are $3,000 ($1,000 extra) per qualifying child, for qualifying children ages 6 through 17 at the end of the tax year; or $3,600 ($1,600 extra) if the qualifying child is 5 or under at the end of the tax year.

Planning point. The tax code measures your child’s age on December 31. For example, if your child turned 4 in July, your child is 4 on December 31.

Phaseout 1. You’ll reduce the 2021 credit amount that exceeds the $2,000 base credit by $50 for each $1,000 (or fraction) by which your modified adjusted gross income (MAGI) exceeds

$150,000 for married, filing jointly, or for qualifying widower; $112,500 for head of household; or $75,000 for all other filing statuses.

Phaseout 2. Once your MAGI exceeds $200,000, or $400,000 on a married-filing-jointly return, then your $2,000 base credit decreases by $50 for each $1,000 (or fraction thereof) that your MAGI is over the thresholds.

In addition, the entire child tax credit is 100 percent refundable as long as either you or your spouse has a principal place of abode in the U.S. for more than one-half of the tax year.

Heads up. Here’s a new wrinkle you need to manage: the IRS will advance you 50 percent of your anticipated child tax credit based on your last filed tax return.

You’ll reconcile the advance payments received with your actual 2021 child tax credit, and if the advance payments exceed your actual credit, you have to pay back the excess with your 2021 tax return.

The IRS will make the advance payments in equal monthly amounts between July and December 2021. You will have access to an IRS online portal where you can opt out of the advance payments or can update your information to avoid having to repay any of the amounts on your 2021 tax return due to a change in circumstances.

Dependent Care Credit—Current Law

In tax year 2020, you could claim a tax credit if you paid someone to care for your under-age-13 dependent or for your spouse or dependent who isn’t able to care for himself or herself.

Your maximum expenses eligible for the credit were $3,000 for one qualifying individual, or $6,000 for more than one qualifying individual.

The credit rate was 35 percent up to an AGI of $15,000. Your credit rate then decreased by 1 percent for each additional $2,000 of AGI (or fraction thereof). Once your AGI was $43,000 or higher, you had a 20 percent credit rate.

Dependent Care Credit—Tax Year 2021

For tax year 2021 only, the maximum creditable expenses are $8,000 for one qualifying individual, or $16,000 for more than one qualifying individual.

The credit rate is 50 percent up to an AGI of $125,000. Your credit rate then decreases by 1 percent for each additional $2,000 of AGI (or fraction thereof). Once your AGI is $185,000 or higher, you have a 20 percent credit rate.

However, there is a new upper limit: once your AGI reaches $400,000, you reduce your credit rate by 1 percent for each additional $2,000 (or fraction thereof) of AGI until the rate is 0.0 percent at an AGI of $440,000.

In addition, the dependent care credit is 100 percent refundable as long as either you or your spouse has a principal place of abode in the U.S. for more than one-half of the tax year.

Employer-Provided Dependent Care Assistance

For tax year 2021 only, the maximum employer-provided dependent care benefit excluded from your income as part of your cafeteria plan goes from $5,000 to $10,500 (or $5,250 for married filing separate).

Premium Tax Credit—Current Law

The Affordable Care Act (Obamacare) created the premium tax credit to help you afford insurance purchased on your state’s health insurance marketplace.

Your premium tax credit is equal to total monthly premiums for the tax year for the second-lowest silver health plan available on your state’s health insurance marketplace, less a certain percentage of your annual household income, with that percentage determined by your annual household income.

The percentage of your annual household income you must pay ranges from 2.06 to 9.78 percent in tax year 2020.

Once your household income exceeds 400 percent of the federal poverty level (FPL), you are no longer eligible for the premium tax credit. For example, the 400 percent thresholds outside of Alaska and Hawaii for tax year 2020 are $67,640 for a household of two,$85,320 for a household of three, and $103,000 for a household of four.

You can receive advances of the premium tax credit based on information you provide to the health insurance marketplace. On your tax return, you then compare your credit with the advance amounts and pay back any advance payments in excess of the actual credit, subject to limits.

New Law—Good Deal

The American Rescue Plan Act of 2021 (ARPA) retroactively removed the requirement to repay any excess advance premium tax credit payments for tax year 2020.

Premium Tax Credit—Tax Years 2021 and 2022

ARPA made several changes to expand access to the premium tax credit for tax years 2021 and 2022.

For tax year 2021 only, if you receive (or receive approval for) unemployment for any week beginning during tax year 2021, then you qualify for the premium tax credit (but if married, you must file a joint return with your spouse), and you will not take into account any of your household income in excess of 133 percent of the FPL for a family of the size involved. The above provision creates larger premium tax credits for most anyone who receives unemployment during tax year 2021.

In addition, for tax years 2021 and 2022 only you can claim the premium tax credit even if your household income exceeds 400 percent of the FPL, and the amount of your household income you must contribute toward your health insurance to calculate your premium tax credit ranges from 0.0 percent to 8.5 percent based on your household income, which is a significant decrease over tax year 2020. The 0.0 percent rate goes up to 150 percent of the FPL.

As you can see, you have far more opportunities for tax credits in 2021.

Melissa Broughton is the proud owner of Busy Bee Advisors, a Sacramento-based Bookkeeping & Tax firm. She can be reached at 916-400-3500 or online.

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