Investment
in Rental Income Properties
This link takes to you what is called publication 17. Chapter nine is about real estate taxation.
A
popular form of long-term investment is real estate rentals. Rentals
can fall
into
several varieties, of which real estate rentals is the most common.
This
material will explain some of the tax ramifications of renting real
estate,
both
residential and commercial.
One
of the biggest benefits of owning rental property is that the
tenants, over
time,
buy the property for you. In addition, if structured properly, the
allowable
depreciation deduction will shelter the rental income. Another
historical
benefit of real estate rentals is capital appreciation.
Before
acquiring a rental property, consider the following:
•
After-tax
cash flow,
•
Potential
for long- or short-term appreciation,
•
Property
condition (with an eye on when you might get stuck
with a large repair bill),
•
Debt
reduction,
•
Type
of tenants,
•
Potential
for rent increases or re-zoning, and
•
Whether
there is community rent control, etc.
Although
most of the considerations are subjective, the after tax
cash
flow can be estimated fairly easily.
Operating
Expense
For
tax purposes, you will figure your profit or loss each year from
operating
the
rental property. Generally, you can deduct all expenses incurred to
operate
the
rental. The following are potential operating expenses that are
deductible:
•
Advertising
•
Cleaning
& maintenance
•
Bank
charges – if a separate account is maintained.
•
Insurance
– fire, casualty and liability
•
Utilities
– gas, electricity, water, cable, etc.
•
Services(1)
– yard care, pool
service, pest control, etc.
•
Rental
commissions
•
Property
management fees
•
Mortgage
interest – on debt to acquire or improve
the
rental.
•
Property
taxes
•
Repairs
– see repairs vs. improvements below. (1)
•
Local
transportation expenses
•
Homeowners
or association dues
•
Tax
return preparation fees
•
Depreciation
allowance – see depreciation below.
(1)
If any individual or company providing these services is paid $600 or
more
during the year, you are required to issue them a 1099MISC.
Repairs
vs. Improvements
When
figuring your profit or loss from operating the rental property each
year
you
can deduct the cost of repairs to the rental property. However,
any
improvements that were made must be depreciated over the
improvement’s
useful life.
How
do you distinguish a repair from an improvement?
•
Repairs
– A
repair keeps your property in good operating
condition
and does not materially add to the value of your
property
or substantially prolong its life.
•
Improvements
–
An
improvement will add to the value
of
the property, prolong its useful life, or adapt it to new
uses.
If you make an improvement to a property, the cost
of
the improvement must be capitalized.
Depreciating
Rental Property
“Depreciation”
is an accounting term for writing off the wear and tear on an asset
that
has a useful life of more than one year and costs over $100.
Generally, rental
real
estate improvements must be depreciated over a period of 39 years.
However,
there
are exceptions for residential rental real estate, which is
depreciated over 27.5 years and most personal property such as
furniture, equipment, etc., which is depreciable over 5 or 7 years.
There are additional special rules applying to land rentals,
leasehold improvements and restaurants.
Passive
Loss Limitations
Rental
real estate income is business income but is not subject to Social
Security taxes. Real estate rentals are also considered passive
activities. Generally, passive activity losses are only deductible to
the extent of passive activity income. However, there are two
exceptions to that rule:
(1)
Active Participation
– If you “actively participate” in the
residential rental activity, you may be able to deduct a loss of up
to $25,000 ($12,500 if you're married, file separately, and live
apart from your spouse for the entire year – but if you're married,
file separately and don't live apart from your spouse for the entire
year, you're not eligible for this break at all) against ordinary
(nonpassive) income, such as your wages or investment income. You
actively participate in the rental activity if you make key
management decisions or arrange for others to provide services.
Active participation does not require regular, continuous and
substantial involvement with the property. But in order to satisfy
the active participation test, you (together with your spouse) must
own at least 10% of the rental property. Ownership as a limited
partner does not count. If your adjusted gross income (AGI) is above
$100,000, the $25,000 allowance amount is reduced by one-half the
excess over $100,000. (If you're married, file separately and are
eligible for the break,the $12,500 allowance amount is reduced by
one-half the excess over $50,000.) Under this rule, if the AGI is
$150,000 or more ($75,000 or more for eligible married taxpayers who
file separately), the allowance is reduced to zero. For these
purposes, AGI is modified to some extent, e.g., you ignore taxable
Social Security income and the Individual Retirement Account (IRA)
deduction, and
(
2 ) Real Estate Professional Exception
– If
you qualify as a “real estate professional” (which requires the
performance of substantial services in real property trades or
businesses), your rental real estate activities are not automatically
treated as passive, and so losses from those activities can be
deducted against earned income, interest, dividends, etc., if you
materially
participate
in the activities.
Any
losses not allowed under these two exceptions are not lost but
suspended, and carried forward indefinitely to tax years in which
your passive activities generate enough income to absorb the losses.
Special
Situations
There
are a number of special circumstances involving the rental of real
estate.
•
First,
Last and Security Deposits
– Generally,
landlords require a new tenant to pay the first and last month’s
rent in advance along with a security deposit. The IRS says that
advance rent payments are income in the year received. However,
security deposits you plan to return to your tenant at the end of the
lease are not income. But if you keep part or all of the security
deposit during any year because your tenant does not live up to the
terms of the lease, then the amount
kept is income for that year.
•
Renting
Part of Property –
If you
rent part of your property, you must divide certain expenses between
the part used for rental purposes and the part used for personal
purposes, as though you actually had two separate pieces of property.
You can deduct the expenses related to the part of the property used
for rental purposes, such as home mortgage interest and real estate
taxes, as rental expenses. You can also deduct as a rental expense
other expenses that are normally
nondeductible personal expenses, such as utilities and home
repairs.
You do not have to divide the expenses that belong only to the rental
part
of your property. Generally, the most frequently-used methods of
allocating
expenses
between personal and rental use are:
(1)
based on the number of rooms in the home, and
(2)
based on the square footage of the home. You can use
any
reasonable method for dividing the expense.
•
Separating
Improvements from Land
– Not
all of the cost of acquiring
real
estate is depreciable. Specifically, the cost of the land is not
depreciable
and
must be separated from the improvements.
•
Renting
to a Relative –
Special
rules may apply when renting a home
or
apartment to a relative. If you rent a home to a relative who: (1)
uses it as
his
or her principal residence
(that is, not just as a second or vacation home)
for
the year, and (2) it is rented at a fair rental value (not ata
discount),
then
no limitations apply. You simply treat it like any other rental
property.
However, if it is rented to a relative below fair rental value, all
of
the expenses, except mortgage
interest
and property taxes, are
considered
personal expenses and therefore not deductible.
•
Vacation
Home Rental–
There are special tax consequences when you
rent
out your vacation home for part of the year. The tax treatment
depends
on
how many days it is rented and your level of personal use. Personal
use
includes vacation use by your relatives (even if you charge them
market
rate
rent) and use by non-relatives if a market rate rent is not charged.
When
determining the personal-use days, do not include days when you
are
performing repairs or fixing up the property.
Selling,
Exchanging
or
Converting the Rental
Buying,
operating and selling a rental property can have profound
tax
ramifications. Rental property, if owned for longer than a year or if
inherited,
will qualify for long-term capital gains when sold. This means any
gain
is taxed at a maximum of 15% with one exception. The exception is
recaptured
depreciation which, depending upon your tax bracket, can be taxed
up
to 25%. When it comes time to cash in on a rental investment, there
are
a number of options available to the owner:
•
Outright
Sale –
When a rental property is sold outright, the entire gain
will
be taxable in the year of sale.
•
Installment
Sale –
If the seller carries back a note (mortgage) for all or part
of
the buyer’s purchase price, the seller qualifies for installment
sale
treatment,
which in effect spreads the taxation of the gain over the life of
the
note.
•
Convert
to Personal Use– The
rental can be converted to personal use of
the
taxpayer and any gain deferred until the property is ultimately sold.
•
Tax-Deferred
Exchange– A
tax-deferred exchange can be used as a means
of
avoiding immediate taxation on the gain from a rental property by
deferring
the
gain into a replacement property.
Business
or Investment Use Requirement –
To qualify for a Sec 1031 exchange, the properties exchanged must
both be held for business or investment use.
Like-Kind
Requirement –
The properties exchanged must be like-kind (similar in nature, but
not necessarily of the same quality). Real estate must be exchanged
for real estate (improved or unimproved qualifies).
Caution:
Sometimes real
estate is held in a partnership or other entity. Generally, an entity
ownership does not qualify as like-kind. Although, tenant-in-common
interests(sometimes referred to as TICS), if structured properly,
can.
Property
Acquired with Intent to Exchange –
If a taxpayer acquires (or constructs) property solely for the
purpose of exchanging it for like-kind property, the IRS says that
the taxpayer doesn't hold the property for productive use in a trade
or business or for investment, and as to the taxpayer, the exchange
doesn't qualify for non-recognition treatment under Code Sec. 1031.
Simultaneous
or Delayed –
The exchange can be simultaneous or delayed. If delayed, the property
received in the exchange must be identified within 45 days after the
property given is transferred. No matter how many properties are
given up in an exchange, a taxpayer is allowed to designate a maximum
of either:
(a)
Three replacement properties regardless of FMV, or
(b)
Any number of properties, as long as the total FMV isn’t more than
200% of the total FMV of all properties given up.
If
a taxpayer identifies replacement properties over these limits,
he/she is treated as if none were identified. A taxpayer can,
however, revoke an identification at any
time
before the end of the 45-day time period.
The
receipt of the new property must be completed before the EARLIER of:
(1)
180 days after the transfer of the property given, OR
(2)
The due date (including extensions) of the return for the year in
which the property given was transferred.
Qualified
Intermediary –
Generally, to qualify for a delayed Sec 1031 exchange, a qualified
intermediary is engaged to hold the funds from the sale until the
replacement
purchase is made. It is important to understand that the taxpayer
cannot take possession of the proceeds from the sale and then buy
another property. If that happens, the event does not qualify for
exchange and is immediately taxable.
Reverse
Exchanges –
It is possible to structure a reverse exchange that complies with the
Section 1031 delayed exchange requirements. However, it requires that
the replacement property be purchased first, by the intermediary,
without the benefits of the proceeds from the property given up in
the exchange. Thus, only taxpayers with the cash financial resources
can accomplish reverse exchanges. Tax-deferred exchanges can be very
tricky and should not be entered into without first analyzing the tax
aspect.
This
is one of the helpful handouts about taxes that we provide. Feel free
to request others. We can email them to you.
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Tax Services
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Tax Preparation at Reasonable Prices
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