The federal income tax law recognizes that you must spend money to make money. Virtually every real estate agent or broker, however small his or her business, incur some expenses. Even an agent or broker who works from home must pay for business driving and insurance. Let’s take a look at the basics for real estate brokers taxes, as well as some valuable deductions that may be helpful during tax time.
If you are a sole proprietor (or owner of a one-person LLC taxed as a sole proprietorship), you are not legally required to pay tax on every dollar your real estate sales business takes in (your gross business income). Instead, you owe tax only on the amount left over after your deductible business expenses are subtracted from your gross income (this remaining amount is called your net profit).
Although some tax deduction calculations can get a bit complicated, the basic math is simple: the more deductions you take, the lower your net profit will be and the less tax you will have to pay.
Example: Karen, a sole proprietor real estate broker, earned $100,000 in commissions this year. Fortunately, she doesn’t have to pay income tax on the entire $100,000—her gross business income. Instead, she can deduct from her gross income various business expenses, including a $10,000 office rental deduction and a $5,000 deduction for insurance. These and her other expenses amount to $20,000. She can deduct the $20,000 from her $100,000 gross income to arrive at her net profit: $80,000. She pays income tax only on this net profit amount.
The principle is the same if your business is a partnership, limited liability company or S corporation: Business expenses are deducted from the entity’s profits to determine the entity’s net profit for the year, which is passed through the entity to the owners’ individual tax returns.
Example: Assume that Karen is a member of a three-owner real estate brokerage organized as a limited liability company (LLC), and is entitled to one-third of the LLC’s income. She doesn’t pay tax on the gross income the LLC receives, only on her portion of its net income after expenses are deducted. This year, the LLC earned $400,000 and had $100,000 in expenses. She pays tax on one-third of the LLC’s $300,000 net profit.
If your business is organized as a regular “C” corporation, it too pays tax only on its net profits.
Real estate agents and brokers can deduct three broad categories of business expenses:
The first money you will have to shell out will be for your business’s start-up expenses. These include most of the costs of getting your business up and running – items such as advertising costs, attorney and accounting fees and office supply expenses. Start-up costs are not currently deductible—that is, you cannot deduct them all in the year in which you incur them. However, you can deduct start up costs up to $5,000 in the first year you are in business. You must deduct amounts that exceed the first-year threshold amount over the next 15 years.
Example: Cary recently obtained a real estate broker’s license and decides to open his own real estate office. Before Cary’s office opens for business in August 2015, he has to rent space, rent office furniture and equipment and create a website. These start-up expenses cost Cary $10,000. Cary may deduct $5,000 of this amount the first year he’s in business (2015). The remainder may be deducted over the first 180 months that he’s in business—$417 per year for 15 years.
Operating expenses are the ongoing day-to-day costs a business incurs to stay in business. They include such things as rent, utilities, salaries, supplies, travel expenses, car expenses, and repairs and maintenance. These expenses (unlike start-up expenses) are currently deductible—that is, you can deduct them all in the same year in which you pay them.
Example: After Cary’s brokerage office opens, he begins paying $5,000 a month for rent and utilities. This is an operating expense that is currently deductible. When Cary does his taxes, he can deduct from his income the entire amount he paid for rent and utilities for the year.
Capital assets are things you buy for your business that have a useful life of more than one year, such as buildings, equipment, vehicles, books and office furniture. These costs, called capital expenses, are considered to be part of your investment in your business, not day-to-day operating expenses.
Large businesses—those that buy at least several hundred thousand dollars of capital assets in a year—must deduct these costs by using depreciation. To depreciate an item, you deduct a portion of the cost in each year of the item’s useful life. Depending on the asset, this could be anywhere from three to 39 years (the IRS decides the asset’s useful life).
Small businesses can also use depreciation, but they have another option available for deducting many capital expenses. They can currently deduct a substantial amount of long-term asset purchases in a single year under a provision of the tax code called Section 179.
Example: Cary spent $5,000 on a computer system for his office. Because the computers have a useful life of more than one year, they are capital assets that he will either have to depreciate over several years or deduct in one year under Section 179.
Certain capital assets, such as land and corporate stock, never wear out. Capital expenses related to these costs are not deductible; the owner must wait until the asset is sold to recover the cost.
Unfortunately, real estate agents and brokers don’t always earn a profit from their business. This is particularly common for part-time agents and brokers. If you’re in this unfortunate situation, you may be able to obtain some tax relief. This could provide you with a refund of all or part of previous years’ taxes in as little as 90 days—a quick infusion of cash that should be very helpful.
If, like most real estate agents and brokers, you’re a sole proprietor, you may deduct real estate losses your business incurs from your other income for the year—for example, income from a job, investment income or your spouse’s income (if you file a joint return).
If your business is operated as an LLC, S corporation or partnership, your share of the business’s losses are passed through the business to your individual return and deducted from your other personal income in the same way as a sole proprietor. However, if you operate your business through a C corporation, you can’t deduct a business loss on your personal return. It belongs to your corporation.
If your losses exceed your income from all sources for the year, you have a “net operating loss” (NOL for short). While it’s not pleasant to lose money, an NOL can provide important tax benefits: It may be used to reduce your tax liability for both past and future years.
You may apply a NOL to past tax years by filing an application for refund or amended return for those years. This is called carrying a loss back. As a general rule, it’s advisable to carry a loss back, so you can get a quick refund from the IRS on your prior years’ taxes. However, it may not be a good idea if you paid no income tax in prior years, or if you expect your income to rise substantially in future years and you want to use your NOL in the future when you’ll be subject to a higher tax rate.
In addition, the carry-back period is increased to three years if the NOL is due to a casualty or theft, or if you have a qualified small business and the loss is in a presidentially declared disaster area. (A qualified small business is a sole proprietorship or partnership that has average annual gross receipts of $5 million or less during the three-year period ending with the tax year of the NOL.) The NOL is used to offset the taxable income for the earliest year first, and then applied to the next year or years. This will reduce the tax you had to pay for those years and result in a tax refund. Any part of your NOL left after using it for the carry-back years is carried forward for use for future years.
There are two ways to claim a refund for prior years’ taxes: You can file IRS Form 1040-X, Amended U.S. Individual Income Tax Return, within three years, or you can seek a quicker refund by filing IRS Form 1045, Application for Tentative Refund. If you file Form 1045, the IRS is required to send your refund within 90 days. However, you must file Form 1045 within one year after the end of the year in which the NOL arose.
You have the option of applying your NOL only to future tax years. This is called carrying a loss forward. You can carry the NOL forward for up to 20 years and use it to reduce your taxable income in the future.
Need to know more about NOLs? Refer to IRS Publication 536, Net Operating Losses, for more information. You can download it from the IRS website at www.irs.gov.