Real estate investments can be a great way to create wealth and also reduce your tax exposure. There are a number of very different ways for your Pennsylvania clients to earn income from real estate investments, such as Airbnb (or equivalent services), rental property, and house flipping, and they are treated very differently by the IRS.
With regard to tax reporting, Airbnb is the simplest form of real estate investment. As of the tax year 2022, Airbnb provides a 1099-K form to each host if both of the following apply:
- The host is a U.S. citizen or resident alien, or the host is operating as an entity organized in the U.S. or under the laws of the U.S.
- The host’s gross earnings from January 1 to December 31, 2022, exceed $600
Your client’s Airbnb 1099-K will list both gross earnings as well as net earnings, which are gross earnings less Airbnb fees and adjustments.
Your Airbnb host client should keep track of all expenses associated with the rental, including all upkeep, improvement, fees, cleaning services and supplies, utilities, mortgage, advertising, and any expenses involved in education on property management. These expenses can be deducted from the net income in order to lower your client’s taxes.
Rental property taxes are more complicated than Airbnb. No 1099 is provided. Like Airbnb, your client should keep track of all possible expenses that can be deducted from income. All ordinary and necessary expenses associated with homeownership and rental management can be deducted. Improvements, such as a building addition, can be depreciated.
Rental income is reported in the year in which it was received. For instance, if your client received rent for January 2023 in December 2022, the January rent is considered part of 2022 income. If your client receives goods or services in exchange for any rent payments, your client needs to report that good or service at its value as rental income.
If your client collects a security deposit, which is intended to be returned at the end of the lease, the security deposit is not taxed. If your client has to withhold part of the security deposit due to damage or a delinquent renter, it is taxed as income in the year the lease ends.
If your client collects the last month’s rent, this is taxable in the year it is received, since the renter does not intend to return this money. It is considered a rent payment.
Rental property becomes tricky when the owner uses the property as a vacation home or lives there for a time. In order to fully deduct all expenses, your client’s use is limited to 14 days or 10% of the days the unit is rented during the year. If your client exceeds this amount, he or she can still deduct expenses, but may not deduct an amount that exceeds the rental income.
Flipping property is the most complex form of real estate investing with regard to taxation. It can be very lucrative, but it is also possible for the taxes to wipe out or even exceed income. If your client is considering flipping, it is best to have your client talk to you first to help him or her make some important decisions on how to best proceed.
House flippers are designated by the IRS as either dealers or investors. The distinction between the two is still being litigated, but as a general rule, someone who buys and sells (flips) houses frequently as a main form of income is likely to be considered a dealer. Someone who buys and sells a house or two in a year is likely to be considered an investor.
Dealers are subject to both ordinary income tax and self-employment tax. Depending on the person’s tax bracket, the total tax could range from 25.3% to as much as 52.3%. For this reason, your client should think very hard about whether it will be worth the tax burden.
If your client is considered an investor, income would be considered capital gains and your client would not have to pay self-employment tax. Short-term capital gains on property held for less than twelve months would be taxed at the ordinary income rate. If your client holds the property for at least one year, capital gains tax will max out at 20%. Therefore, this would be the scenario with the lowest possible tax rate. Again, all expenses can be deducted to reduce the profit and thus reduce taxes, so be sure to encourage your clients to maintain detailed records of all expenditures.
Dive deeper into the details of real estate taxes in order to provide your clients with the best possible service. If this is an interest of yours, becoming an expert in real estate taxation could develop into a valuable niche for you. Check out our educational opportunities at PSTAP for this and other specialized subjects to grow your practice.