RENTAL REAL ESTATE AS AN INVESTMENT

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.  Specifically excluded from this discussion are transient rentals, where the tenants rent for an average of seven days or less, such as motels and equipment (machinery) rentals.  Both are considered self-employment businesses for tax purposes and thus subject to self-employment taxes. 

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, there are a number of things to consider, which include 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.

For tax purposes, you will figure your profit or loss each year from operating the rental property.  Generally, you can virtually deduct all expenses incurred to operate the rental.  Browse through our list of potential operating expenses that are deductible. In addition, you will need to keep track of repairs and improvements and know how to distinguish between the two.

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) where there is active participation, and (2) real estate professional exception.  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. To the extent your passive losses from an activity aren`t used up in this fashion, you will be allowed to use those losses in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.

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 such as whom to rent to, the rental terms, approving capital expenditures, etc. You also can show active participation if you 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.

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. Please call this office for special situations.

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. A frequent question is whether to treat these payments as current-year income or income to a future year. 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.

Operating Expenses

For tax purposes, you will figure your profit or loss each year from operating the rental property. Generally, you can virtually deduct all expenses incurred to operate the rental. The following is a list of 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 later.
• Local transportation expenses
• Homeowners or association dues
• Tax return preparation fees
• Depreciation allowance – see depreciation later.

(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.

Outright Sale

When a rental property is sold outright, the entire gain will be taxable in the year of sale. Let’s assume (without considering property improvements or buying or selling costs) that you purchase a rental for $50,000 and then several years later sell it for $300,000. Over the period of time that it was a rental, you took $10,000 in depreciation deductions. Your tax basis in the property at the time of sale would be $40,000 (your cost of $50,000 less the $10,000 taken in depreciation). Thus, your gain would be $260,000 (the sales price of $300,000 less your tax basis of $40,000). The recaptured depreciation of $10,000 can be taxed as high as 25%, depending on your tax bracket and the balance of the gain ($220,000) is taxed at a maximum of 15%.

Real Estate Professional

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. Please call this office for additional details associated with this limited exception.

Renting Part of Property

If you rent part of your property, such as a room or a portion of the house, you must divide certain expenses between the part of the property used for rental purposes and the part of the property 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 a part of other expenses that normally are nondeductible personal expenses, such as utilities and home repairs (such as painting the outside of your house). You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint the room that you rent or pay premiums for liability insurance in connection with renting a room in your home, the entire cost is a rental expense. If you install a second phone line strictly for your tenant’s use, all of the cost of the second line is deductible as a rental expense. You can also deduct depreciation on the part of the property used for rental purposes, as well as on the furniture and equipment used for that purpose.

Generally, the most frequently-used methods of allocating expenses between personal use 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. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them.

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 (not at a discount), then no limitations apply. You simply treat it like any other rental property. However, if it is rented to a relative at below fair rental value, all of the expenses, except mortgage interest and property taxes, are considered personal expenses and therefore not deductible. Thus, it is important to set a “fair” rental rate when renting to a relative. Factors to look at include comparable rentals in the area and whether “side” gifts were made by you to your relative, which could be reasonably interpreted to be the bargain element. Relatives for this purpose include your spouse, child or grandchild, parent or grandparent, and siblings.

Repairs vs. Improvements

When you figure 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. Repainting your property inside or out, fixing gutters or floors, fixing leaks, and replacing broken windows are examples of repairs. However, if the repairs are part of an extensive remodeling or restoration of your property, the whole cost is an improvement.
  
  
• 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. The capitalized cost can generally be depreciated as if the improvement were separate property.

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. Thus, you should identify and document at the time that you acquire real estate, the part of your overall acquisition cost allocable to improvements. One way to accomplish this is to retain a qualified real estate appraiser to make an allocation between land and improvements, or if the real property tax bill for the property includes an allocation, and most do, use that allocation. When using the property tax, the total of the allocation between the land and improvements probably will not equal the actual purchase price. In that case, simply allocate the land and improvements in the same proportion as the property tax bill. Any improvements made after the original purchase should be accounted for and depreciated separately, since there is no land allocation associated with the improvement.