Owning the right rental real estate can be a profitable endeavor, and often even with a property that’s making money, the tax bite can be minimal or even provide you with a deduction.
Of course not all properties will be money makers, and while no one likes losing money on an investment, saving tax dollars softens the blow if you are eligible to take the deduction.
Keeping up a rental home comes with many – and more – of the expenses of maintaining your personal home, but unlike some of your home expenses, these are tax deductible. You’ll probably remember the bigger things, such as hiring a plumber, but don’t forget about the little ones, like the Windex you buy to wash the windows or the cost of making new keys.
Do you drive to check on the property? Track the miles, too. Property taxes, insurance, accounting and legal fees, repairs; all those help reduce your taxable income.
Not all expenses deductible
Not all expenses of running your rental real estate property currently are deductible. For instance, you won’t be able to deduct your entire mortgage payment, only the interest, since a portion of your payment goes toward your principal.
And improvements – things that add value to your property or become a permanent part of it rather than just maintaining it – must be capitalized and depreciated. In other words, you can’t deduct the cost of putting on a new roof all in one year, but rather you can deduct a portion of it each year over its useful life.
You are allowed to write off a portion of the building each year against your income as well. For ease of math, let’s say that you paid $300,000 on Jan. 1 for your property, and $25,000 of that represents the value of the land. That leaves a building value of $275,000, which you can deduct evenly over 27.5 years, at $10,000 per year.
Even if your property ends up with a profit of $10,000, the depreciation deduction cancels it out. Better still, if your profit before depreciation is 4,000, for example, depreciation creates a $6,000 loss.
Unfortunately not all taxpayers will be allowed to deduct the loss in that year. Most rental real estate investments are considered to be passive activities, and therefore losses are only allowed to offset other passive activity income.
However, in the case of rental real estate, the loss can be deductible if you had what is called “active participation.” That means that you participated in management decisions for the property such as choosing the tenants, deciding on repairs to make, or drafting the rental terms. You can be considered an active participant even if you hire a management company to assist in carrying out your decisions.
Being an active participant means that you can deduct up to $25,000 in losses each year against all of your income, as long as your income does not exceed the limits. For a married couple, the deduction begins to phase out at $100,000 of modified adjusted gross income, and completely phases out at $150,000. Married couples who live together but file separately lose the ability to take the deduction at all.
It’s not all bad news, though, since those losses that cannot be deducted currently are not lost for good but suspended until you have a year of profit (which then will reduce the profit) or the year the property is sold or otherwise disposed of, when all suspended losses will become deductible.
Should you be able to clear the higher hurdle of being considered a real estate professional with material participation in each of your rental activities, then the losses are deductible, regardless of your income level. In general, a real estate professional is someone for whom more than half of his or her personal service activities are spent on real estate, and that activity is more than 750 hours per year.
The material participation test then is applied to each property separately. Therefore, if you own several properties you may qualify for one and not the others, depending on how you spend your time.
There are seven tests for material participation; meeting one is enough to pass. Some of the tests include spending 500 hours or more in a year participating in the activity of the property; spending more time actively in the property than anyone else (owners or not); having materially participated in the property’s activities in at least five of the previous 10 years; and participating on a regular, continuous, and substantial basis.
What about years in which there is a profit to report? That net profit will be added to your income, just like your wages or bank interest is, and taxed at your ordinary income tax rate, plus any additional taxes you may be subject to, such as alternative minimum tax or the Medicare investment income surtax. No one enjoys paying taxes, but given that profit is the motive, if you’re in the position to recognize profit, that’s a sign of success.
When it comes time to sell the property, there are a few calculations to make in determining any tax due or saved. Like the sale of any investment, you first must know your cost basis, or the adjusted starting point, which is the price you paid for the property, plus any improvements, and less depreciation taken over time.
Let’s say that $300,000 property was depreciated for 10 years, and sold for $350,000. The $100,000 of depreciation taken ($10,000 a year for 10 years) would make the basis $200,000, for a total gain on the sale of $150,000. The first part of that, the $100,000 depreciation portion, is taxed at a maximum of 25 percent while the additional gain of $50,000 is taxed at your normal capital gains rate, which for most will be 15 percent.
So the depreciation deduction you enjoyed over the years is essentially temporary, being recaptured at the sale.
Before you think about not taking it, the IRS applies the recapture to depreciation that was either allowed or allowable, so whether you took it or not you’ll be taxed on it. If you were holding suspended passive losses from years you were not eligible to deduct them, those all come back into play now in the sale year, and offset your gains and your other income if they are large enough.