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Perhaps one shouldn’t be surprised that new real estate investors fall into the same tax traps again and again. Real estate burdens investors—especially new investors—with some tricky tax accounting.

But just because some other newbie makes t

According to USFDA, a combination product is one composed of any combination of a drug and device; biological product and device; drug and biological product

hese mistakes, that doesn’t mean you need to. You just need to know where the traps are so you avoid them. And here are the biggest real estate tax traps you don’t want to fall into:

Tax Trap 1: Passive Loss Limitation

On paper

; or drug, device, and biological product and fixed dose combination would include two or more combinations of drug.

Examples of combination products may in

at least, real estate often loses money. Even if the rent pays the mortgage and the operating expenses, the books still show a loss because you get to write off a portion of the purchase price through depreciation each year.

If a rental hous

lude drug-coated devices, drugs packaged with delivery devices in medical kits, and drugs and devices packaged separately but intended to be used together.

e that cost $275,000 breaks even on cash flow, for example, you might also get a $10,000 annual depreciation deduction. If your marginal tax rate is 28%, that depreciation should save you $2800 annually.

Sounds sweet, right? Well, it is—or sh

here is enormous increase in the number of combination products entering the market in the recent years. Combination products have proven advantages but fixe

ould be. Except that the U.S. Congress labeled real estate investment a passive activity and said that, except in a couple of special circumstances, you can’t write off passive activity deductions unless overall you show positive passive incom

d dose combinations are still in the process of convincing regulatory authority on their advantages over the single ingredient formulations.

Combination pro

e.

This passive loss limitation rule means that many real estate investors don’t get to use tax saving deductions from real estate—or least not annually.

Two loopholes, courtesy of Congress, do exist that let you write off deductions from re

ucts have become life saving products for the pharmaceutical companies who doesn’t have many innovative molecules in their product pipeline and have been inc

al estate even if overall you show a loss from real estate investing. If you’re an active real estate investor with adjusted gross income below $100,000, you can write off up to $25,000 of passive losses annually. (If your income is between $1

easingly used in the product life cycle management. Even the companies having product patents are trying to extend their product life cycle through the combi

00,000 and $150,000, you get to write off a percentage of the $25,000. Ask your tax advisor for the details.)

Here’s the second loophole: If you’re a real estate professional, Congress says the passive loss limitation rule doesn’t apply to yo

nation products and maximize the revenues. But the companies involved in this practice are overlooking that they are burdening the patients both economically

u when it comes to real estate. A real estate professional, by the way, is not someone who’s licensed as an agent or broker. The law instead creates a time-based test: A real estate professional is someone who spends at least 750 hours

and physically. They need to rightly judge the benefits of the combination products and they have to even look at the risks involved when combining the produ

a year and more than 50% of their time working as a real estate agent, broker, property manager or developer.

Tax Trap 2: Capitalization of Improvements

The next mistake that new real estate investors make? Thinking they can write o

ts. Some of the combination products were well accepted by physicians while others suffered. Companies involved in development of combination products are fi

ff the amounts they spend to improve the property. Sometimes you can. Often you can’t.

Here’s why: Any expenditure that increases the life of the property or improves its utility needs to be depreciated over the next 27.5 years (if the proper

ding difficulty in defining their combination products and facing various challenges from selecting a combination to marketing it.

Following aspects would a

ty is residential) or over 39 years (if the property is nonresidential). You can’t, therefore, write off the money spent improving or renovating a house—except through depreciation.

I’ve seen new real estate investors in tears about this wrin

dd to the challenges in developing combination products:

Which markets to tap where the combination products can do fairly well?
Which combination prod

kle. Some investor draws, say, $20,000 from his IRA or 401(k) to fix up some rental. He figures he’ll be able to write off the $20,000 as a tax deduction in the year improvements are made.

No way. Instead, he’ll have to write off the $20,00

cts are meaningful and rational?
Which therapeutic categories to select?
Which Combinations can address unmet needs of the patients?
Do combin

0 at the rate of a few hundred bucks a year over the next three or four decades.

The trick with renovation—if you want to call it that—is to keep the property well maintained as you go. Repainting, new carpeting, general repairs—these items s

tions increase the patient compliance?
What would be the developing cost?
How to tackle the risks encountered during combination product developmen

hould all be all deductions in the year of expenditure (er, subject to the passive loss limitation rule discussed as the first tax trap.)

Tax Trap 3: Missing the Section 121 Exclusion

Here’s the final tear-jerker. And I see it several

t?

As combination products don't fit into the traditional categories of drugs, medical devices, or biological products, the USFDA is in the process of devel

times a year. Someone decides that rather than sell their principal residence when they “move up” to a larger new home, they’re going to turn the original home into a rental.

This is a disastrous decision most of the time because of Section

ping new procedures for reviewing their safety, efficacy and quality.

Professional from academic institutions, pharmaceutical industries, health care indust

121 of the Internal Revenue Code . Section 121 says that if you’ve owned a home and lived in a home for at least two of the last years, you won’t pay any tax on the first $250,000 of gain on the sale ($500,000 of gain in the case of someone wh

y and representatives from various regulatory agencies are working out to design the regulatory requirements for manufacture and sale of combination products

o’s married and filing a joint return).

By converting a principal residence to a rental property, you turn tax-free gain into taxable gain if you don’t sell the property in the first three years.

Two quick notes about goofing up the Section

.

As there is an increasing trend of the combination products companies manufacturing such products should be able to tackle the problems involved in the de

121 exclusion. If you don’t have appreciation in your old principal residence, you’re not losing any Section 121 benefit by converting to a rental.

Second, if you do have a lot of appreciation in your old principal residence and want to use t

elopment. They need to be wiser in analyzing the market trends and the regulatory requirements.

Companies that provide selfless information through particip

hat equity to acquire a rental property, consider this: Sell the old principal residence when you move out so the gain is excluded from taxable income. Then use the tax-free proceeds to purchase another rental—perhaps even the house next door.

tion in industry events and feedback to regulatory authorities would be able to face the challenges and will be successful in developing combination products

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