It’s a great time for landlords in many areas. The percentage of homeowners is steadily declining, and there aren’t signs it will turn around soon. It’s tough for many people to be approved for mortgages, and interest in being a homeowner is down. That means more people are renting. Even better, there aren’t a lot of new properties being built. Vacancy rates are falling and rents are rising in most places. Now, you can generate positive cash flow from renting a home in a number of locales.
Because today’s market favors landlords, those who are downsizing or moving to a new location for retirement might want to consider keeping their old homes and renting them for at least a few years. Others might want to consider renting their vacation homes or buying a future retirement home now and renting it until you retire.
When you decide to rent a home, understanding the tax write offs can dramatically increase the after-tax cash flow from a property.
The first step is to get a valuation of the property. This is especially important, as you’ll see later, when converting a personal use property you’ve owned for a while into a rental property. Ideally you pay for a professional appraisal. An alternative is to have real estate brokers develop valuations and hope that they’re all in the same range and easily can be averaged. You need the land and building to be valued separately.
In this visit we’ll discuss the rules for property that will be rented full time. There are other rules for properties that you rent part time and use part time. In those cases, for example, you’d have to keep a log of how the property is used each day and allocate expenses between personal and rental use. The details of those rules will wait for another day.
When you rent a property full time, the deductions for interest and real estate taxes move from Schedule A of your income tax return to Schedule E. On Schedule E you report the rental property as a separate business. You report all the rental income and from that you deduct the expenses of owning and maintaining the property.
Deductible expenses on Schedule E include mortgage interest, property taxes, homeowners’ association fees, insurance, any property management fees you pay, maintenance, and repairs. You also can deduct the cost of traveling to the property to look after it when those costs are reasonable in relation to the value of the property and rental income. You can’t deduct capital improvements that increase the value of the property or extend its useful life. These are added to the depreciation basis, which we discuss next.
A major deduction often is depreciation. The tax code allows a residential rental building to be depreciated on a straight-line basis (equal annual deductions) over 27.5 years. Land is not depreciated; only the value of the building is depreciated.
When a property is newly purchased for rental, the depreciation basis is the cost. When a property that was held for personal use is converted to a rental property, the depreciation basis is the lower of the current market value and the original cost plus the cost of any improvements. For many properties, the current value is lower than the original cost, so current value will be the depreciation basis. That’s why you need a valuation, to support the depreciation basis. But if you bought the property some years ago, your original cost is likely to be the depreciation basis.
It’s likely that even in today’s hot rental market, you’ll have a tax loss each year after deducting depreciation and the other expenses.
When your rental property generates net taxable income, it’s taxed as ordinary income. When there’s a tax loss, you might be able to deduct that loss against other income.
Rental real estate losses are “passive losses” in the tax code. When your adjusted gross income is $100,000 or less (the limit is the same whether your are single or a married couple filing jointly), you can deduct up to $25,000 of rental real estate losses each year against other income. The $25,000 allowance is phased out as AGI rises until it is eliminated at AGIs of $150,000 and above.
When the loss isn’t deductible because of the income limit or $25,000 annual limit, it is suspended and carried forward to the future. It can be deducted against any future passive income you earn or against any income when you dispose of the property. Passive income in this context doesn’t include income from portfolio investments, such as stocks, bonds, and mutual funds. Passive activities tend to be businesses and partnerships in real estate, oil and gas, and the like.
There’s an exception to the suspension of losses when you quality as a real estate professional. You can deduct the real estate rental losses against other income in an unlimited amount when you’re a professional. To qualify you need to spend at least 50% of your time working in the real estate business and spend at least 750 hours a year in the business. The rules are detailed and complicated and require you to account for your hours. If you want to qualify as a real estate pro, be sure to plan with a good tax advisor.
Eventually you’ll sell the property. If it was a rental property and you sell at a loss, you can deduct that as a capital loss. But only the loss that occurred after you converted the property to a rental is deductible. Declines in value before that are personal and not deductible.
When you sell at a gain, it’s possible you’ll be able to exclude the gain from income. You can exclude the gain when the home was used as your principal residence for at least two years in the last five consecutive years before the sale. Then, you can exclude up to $500,000 of gains if you’re a married couple filing jointly.
For example, if you lived in the home as your principal residence for at least the last two years, you can rent for the next three years, sell it, and exclude any gain. Or you can rent it for a while. Then re-establish it as your principal residence for at least two years, and then sell it and exclude the gain if the law hasn’t changed.
Whether you can exclude the gain or not, you’ll owe taxes on the amount you deducted as depreciation. It doesn’t qualify for the exclusion and might not qualify for long-term capital gains.
There are non-tax aspects to being a landlord to consider. The home is likely to have times when it’s empty between tenants and you don’t earn any rent. You have to find good tenants who’ll take care of the property and pay the rent promptly. You also have to manage the property, which means taking care of repairs and upkeep, and that periodically means late night or weekend phone calls regarding some kind of quickly-needed repair. When you can’t or don’t want to handle these yourself, you need to hire a property manager or contractor who will charge a fee for the service.
When you have questions about the details of these issues, go first to the free publications on the IRS web site at www.irs.gov. You can find the basics in Publication 17, Your Federal Income Tax. Publication 527 covers Residential Rental Property. Publication 925 details Passive Activity and At-Risk Rules while Publication 946 explains How to Depreciate Property. Also read the instructions for Schedule E and Forms 4562 and 8582.
RW July 2012.
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