Rental properties can be great for a lot of reasons. They can provide relatively passive income, positive cash-flow, tax deductions, and asset appreciation. However, if that were always the case, everyone would own one. It is critical to understand the financial and tax implications of owning a rental property before getting too involved in the real estate industry. This knowledge will also help you understand when it’s time to dump your property and move on to something else.
Here are the very basic tax implications of owning a rental property. You report your rental income and expenses on schedule E on your tax return. You are required to keep records of all rent received and all expenses paid. Expenses generally include mortgage interest, real estate taxes, cleaning, maintenance, repairs, management fees, advertising, legal fees, supplies, utilities, and depreciation. There may be more, but these are the most common. After deducting all of your expenses, you are left with either a net profit or a net loss. Profits create more taxes due, and losses may save taxes (sometimes).
The most important thing to keep in mind with your basic rental property is that you always want to maintain positive cash-flow. That means you always want to collect enough rent to cover your mortgage payment and all of your expenses. Although you may show a loss on your tax return due to depreciation (discussed later), positive cash-flow is the signal that you are likely collecting enough rent and not losing your shirt on the property. Aside from this, here are some rules to keep in mind throughout your investment.
Rule #1: Keep good records
Simply by owning a rental property and filing a separate schedule on your tax return, your risk of an audit increases. But don’t panic! Audits are not that painful if you just keep good records and tell the truth on your tax return.
I recommend that all of my clients keep a spreadsheet recording all of their expenses. On another tab, I have them keep track of their time spent each day either working on or managing the property, adding notes to each activity about what was done and by whom. Aside from this, I always recommend keeping all of your receipts for any expenses you will deduct. Keep them organized by year at the very least. If you have multiple properties or a multi-unit property, I recommend using accounting software (Quickbooks Online) to keep track of these records.
Keeping these records is also critical to claiming losses (discussed below) and taking the qualified business income deduction in accordance with the Tax Cuts and Jobs Act (discussed further below).
Rule #2: Be aware of passive activity loss limitations
The IRS generally considers rental activities to be passive. If you own a rental property and are excited about claiming some losses to save on taxes this year, be aware first that passive losses are not always deductible.
Generally, passive losses can only be used to offset passive income. This means that they can’t be used to decrease your income from your job or other non-passive businesses you own. They can usually only be used to offset income from other rental properties or income from businesses in which you don’t materially participate.
This can be frustrating for rental property owners, especially after rough years with high expenses or low income (you know, like 2020 for most landlords). However, there is an exception if you actively participate in your rental activity. Active participation involves making management decisions such as approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.
If you actively participate, you may be able to claim up to $25,000 in losses each year. However, there is a phaseout. For 2020, passive losses may be limited once your modified adjusted gross income reaches $100,000. Once it reaches $150,000, passive loss deductions are completely disallowed.
The losses that are disallowed aren’t gone forever though. They are suspended and carried forward each year until they can be taken. They can be taken in three scenarios. The first is in a year when you have passive income either from a different property or from the same property. The second is if your income drops below the phaseout threshold. The third is when you sell the property. More on property sales in the last section.
Rule #3: Check if you qualify as a real estate professional
One of the biggest problems rental property owners have is the inability to deduct their losses each year on their taxes when they are phased out from passive activity rules. One exception that allows some individuals to deduct losses regardless of income levels is the real estate professional designation. To be considered a real estate professional, you have to meet both of the following criteria:
- More than half of the personal services you performed in all trades or businesses during the year were performed in real property trades or businesses that you materially participated in.
- You performed more than 750 hours of services during the tax year in real property trades or businesses that you materially participated in.
See IRS publication 925 for more information on this. Generally, if you meet both of these criteria, you should qualify as a real estate professional. This allows you to deduct any losses from activities that would generally be considered passive under normal circumstances. Claim your losses on line 43 of your schedule E if you are a real estate professional.
BE AWARE: If you claim to be a real estate professional and are taking your losses, make sure you follow all of the record-keeping requirements listed in Rule #1.
Rule #4: Understand what depreciation is and how it can come back to haunt you
Many real estate seminars like to tout how wonderful depreciation deductions are. “Take tax losses while you’re swimming in cash!!” Though it’s fun to pretend you found a loophole and the government is too stupid to notice, be aware that they will come clawing back at your money later.
While you own a rental property, you take depreciation deductions each year. If you buy a residential property, you deduct the cost of the property (excluding any amount allocated to land) over 27.5 years. For commercial properties, the time frame is 39 years. These are depreciated on a straight-line basis, meaning you essentially take the same deduction each year until you reach the end of the time frame or sell the property.
It is important to allocate some part of the purchase price of your property to the land. Land cannot be depreciated. You can usually get a good idea of how much to allocate by looking at the assessed value of the land and the building for real estate tax purposes. Take each as a percentage of the total and apply it to the total purchase price of the property.
The most important thing to understand about depreciation is that it is a tax deferral. You take depreciation deductions each year and are deferring taxes into the future. Depreciation deductions decrease your cost basis in the property.
So if you purchase a property for $200,000 and sell it for $250,000, you may think, “I have a $50,000 gain, so I will save some of the money to pay taxes on $50,000.” What you may not realize is that your basis has likely been reduced by depreciation over the years. If you have taken depreciation totaling $100,000, you are actually looking at a gain of closer to $150,000 when you sell the property. These can leave property owners with a big surprise come tax time.
One thing that softens the blow is that rental properties are generally considered section 1250 property. Gains on sales of section 1250 property are taxed at a maximum rate of 25%, compared to the current 37% maximum federal rate. This means that you may have taken tax deductions that reduced your tax at a rate of 37%, and you only have to pay back 25% at most. Still painful, but it’s a pretty generous outcome.
Another thing that can help soften the blow is taking any suspended losses from prior tax years. If losses were suspended due to passive activity loss limitations in prior years for this property specifically, they can be taken in the year of sale. This can help offset the depreciation add-back in the year of sale. Check with your accountant to see if you have any suspended losses before selling your property.
Rule #5: Take advantage of the Qualified Business Income Deduction whenever possible
The Qualified Business Income (QBI) Deduction is something that was new starting in 2018 with the Tax Cuts & Jobs Act. It allowed qualified pass-through businesses to take a deduction of 20% of their net business income. This is only relevant if you are showing profits on your rental properties.
If you are showing a profit, this deduction can help reduce your tax liability. To qualify, you need to keep separate books and records for each property and maintain records of any services performed on the property by you or any other person. You also need to make sure the property is not a triple-net lease. This is when you make the tenant responsible for payment of rent, taxes, utilities, and any maintenance on the property. Essentially if you just collect rent and do nothing else, the IRS will not recognize your rental property income as qualified business income.
If you spend at least 250 hours per year working on your rental property, maintain separate books and records, and keep records of all services performed expenses paid, you may qualify for a safe-harbor election. This would allow you to claim the QBI deduction just by meeting these criteria. You can still qualify for the deduction if you don’t, but I generally recommend doing at least this to ensure you can get the deduction.
Those are the basics of owning a rental property. If you made it all the way to the bottom of this page, congratulations. I know that wasn’t easy. If this stuff puts you to sleep like it does for most people, book a free consultation and I’ll guide you through the process.