Rental Property Taxation
Throughout my career, I have a seen a ton of confusion and general misinformation about the tax implications of owning rental real estate. Let’s talk through how it actually works so you can make informed decisions rather than listening to children on TikTok and the wonderful advice they have to offer. This newsletter is going to have multiple parts, so this week we’ll just talk about what happens while you own the property.
Taxes While You Own It
So you’ve purchased a property and found yourself a tenant to rent it out. The tenant pays you rent every month (hopefully), and you pay expenses. These expenses generally include things like your mortgage on the property, association dues, utilities, repairs, etc. At the end of the year, we basically need to create a profit and loss statement on your tax return on a form called schedule E. We start with your rental income for the year and then deduct your expenses.
One of the more common misunderstandings is what to do with your mortgage payment. Most people think they can deduct the mortgage payments made on the property, but that’s not entirely true. You technically can’t deduct the payments towards the principal of the loan. That means that we can only take a deduction for the interest paid on your loan, the real estate taxes, and any insurance or other expenses worked into your mortgage payment.
Another commonly misunderstood deduction is depreciation. Depreciation is the deduction that you take for the actual cost of the property that you purchased. When you purchase a $100,000 property, the IRS doesn’t just allow you to take a $100,000 deduction that year. Instead, they make you deduct the cost of the property over a period of time. Current tax laws say that residential rental properties have a useful life of 27.5 years. Commercial rental properties, on the other hand, have a life of 39 years. Land does not depreciate for tax purposes. Here’s an example of how this works.
You purchase a residential property for $130,000. Of this purchase price, you determine (based on property tax records or another acceptable method), that $20,000 of your purchase should be allocated towards the land that the building sits on. The other $110,000 is the depreciable portion of the property. Each year, you’ll take a deduction on your schedule E for $4,000 ($110,000 / 27.5 years) for depreciation. This figure reduces your net income from the property, which reduces the amount of profit you’ll need to pay tax on each year.
To put it all together, let’s say I have $14,000 in rental income, $6,000 in mortgage interest, $2,000 in real estate taxes, and $4,000 in depreciation deductions. I’m left with a net profit on my schedule E of $2,000. This gets folded into my taxable income, and I’ll be taxed on this at ordinary income tax rates. That means we take this $2,000 and likely multiply it with our current marginal tax bracket. For most people, this is somewhere between 22-24%, but can be much higher or lower depending on your situation.
Passive Activity Loss Limitations
Here’s the whole reason why rental properties aren’t the magical tax haven they are often cracked up to be. If you are not a real estate professional (which is something we’ll define in the next article, but you probably aren’t one), you may be limited on the amount of losses you can deduct from your rental property if your depreciation and other deductions exceed the income that you collected. For example, let’s say I collect $10,000 in rental income from my tenant. I pay $6,000 in mortgage interest, $2,000 in real estate taxes, and I have a $4,000 depreciation deduction. In my brain, this sounds perfect. I technically have a profit of $2,000 for the year when I total up my cash in and cash out, but I get to take a $2,000 loss on my taxes due to the depreciation of the property. Positive cash flow AND a tax write-off. What a dream!
The problem is that I also have a W-2 job that pays me handsomely. If my modified adjusted gross income is above $150,000, I cannot deduct losses from passive activities unless I have other passive income to offset them. That means my $2,000 tax loss on the property gets suspended into future years. I just have to carry forward this $2,000 every year until one of two things happens. The first is that I have enough passive income from this property or another property to use up that $2,000 loss. If that doesn’t happen, I realistically won’t be able to recognize the loss until I sell the property. This can create frustrating tax results especially in the case of years with large losses. I’ve seen many clients have a bad tenant and boatloads of repairs in one tax year, and they’re often frustrated when I tell them that all the money they spent will be carried forward until they sell the property.
It’s so important to understand this when you’re trying to make tax planning decisions. Spending money on your property does not always lead to a better tax outcome in the year you spend it. It may help in the year of sale or in a future year, but evaluating your whole situation for the tax year is critical to understanding the benefits of any write-offs you’re planning on taking.