The Biggest Tax Mistake Real Estate Investors Make

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It's that taxing time of year, so break out your pencils and start sweating.

If you're a real estate investor, it's easy to run afoul of the complicated IRS tax laws. To start with, if you own investment real estate, you first have to figure out which category of real estate investor you fit into:

• Active Real Estate Professionals make the decisions about buying, selling, and leasing their investment real estate. The IRS says active real estate professionals spend more than 50 percent of their work life actively engaged in the business of buying, selling and managing your properties, which has to amount to at least 750 hours per year.
• Passive Real Estate Investors contribute money to the purchase or upkeep of the property but don't participate in the day-to-day property management. Passive investors are limited to $25,000 in losses due to their real estate.

If you decide that you're an active real estate professional, the IRS then asks you to make a choice between whether you're a flipper or a long-term investor.

The IRS considers you to be a flipper if you buy and sell real estate properties frequently. What's the magic number?
Chet Burgess, an enrolled agent who owns Brookwood Tax Service, in Atlanta, says there's no magic number of sales to turn you into a flipper. But if you buy and sell more than one property per year, Burgess says your houses could be treated like retail inventory and the sales might be taxed at ordinary income tax rates. Ouch!

Even if you buy and hold your properties for at least a year (the typical point at which long-term capital gains tax rates kick in), your properties might still be treated as retail inventory and taxed at ordinary income tax rates, Burgess explains.

Instead of flipping your investment properties, if you buy, hold and rent them out, the IRS will treat you as a long-term investor, granting you favorable tax rates.

So, what's the single biggest tax mistake real estate investors make?

According to Merry Brodie, a CPA and enrolled agent, and Bill Nemeth, also an enrolled agent, the single biggest tax mistake real estate investors make is not thinking through the tax consequences of their real estate investments before they start shopping for deals.

As Burgess puts it, "Over the long term, real estate has been a very good investment for a lot of people." But by being smart about the tax consequences of investing, you can turn a very good investment into a great one.

More Tax Tips:

• Beware Roth IRA Conversion Pitfalls
• Lower Your Taxes in Retirement
• Why You Need to Review Your Estate Tax Plan
• Do This One Thing With Your Taxes First

Ilyce R. Glink is the author of several books, including 100 Questions Every First-Time Home Buyer Should Ask and the upcoming Buy, Close, Move In!. She blogs about money and real estate at ThinkGlink.com.