Many of our clients own rental properties, so we often help them throughout the year, tracking expenses and calculating income. Rental property can be either a multifamily dwelling that you purchase with the intention of renting out the individual units, a single-family home, or a commercial property. If you already own property, then you know real estate is generally considered a long-term investment, since liquidity is normally not an option. Income-producing rental property receives certain favorable or perhaps unfavorable tax treatment.
Tax Advantages
Even after the recession, properties can still appreciate in value, assuming you get the property at the right price. Another advantage is that the rental property could produce what we call “positive cash flow,” when your rental income exceeds your actual out-of-pocket expenses. However, this is also taxable income. The ideal situation would be to have positive cash flow and a tax loss produced by depreciation.
Some common tax write-offs with all real estate include mortgage interest and real estate or property taxes. With rental property, you can also deduct any and all expenses you incur to operate that rental. The most common ones would be utilities; insurance; supplies; condo fees or H.O. A. dues; professional fees, such as attorneys, CPAs, property management companies and travel expenses. These are duductible as long as these fees are for work related to your rental activity. You can also write off repairs and improvements; however, these can be tricky because you can deduct repairs, such as, fixing a leaky faucet or replacing a faulty light switch, but improvements, like a new roof, retaining wall or boat dock, are not deductible all at once. They must be depreciated over a certain number of years assigned by the IRS, depending on whether the property is a residential or commercial rental. Remember repairs maintain or keep your property in good condition and improvements add value to the property or prolong its useful life.
As mentioned, rental property is also subject to depreciation, so when you buy a rental property the actual cost of that house, apartment building or other rental property is not deductible in the year you buy it. Depending again on the type of property it is and whether it’s residential or commercial, you are allowed to deduct a portion of the cost of your rental property each year. This also applies to certain repairs and such features as furniture, appliance, fixtures, etc. Be aware, you might be able to deduct a much larger portion of depreciation in the earlier years if you use segmented depreciation. In this case, you should consult a tax professional regarding a cost segregation study.
Vacation homes are subject to what is called the 14-day or 10% rule. You can rent your vacation home for up to 14 days a year and pocket the rental income without being required to declare it on your income tax return. If you rent your vacation home for more than 14 days a year, you must report all of the rental income because the IRS now deems it as a rental property. In this case, you will then qualify to deduct some offsetting expenses.
Additionally, if it is a rental property and not primarily used personally, you can personally use it for up to the lesser of 14 days each year or 10% of the total time rented for the year, and then all of the related deductions do not have to be allocated. If you exceed the lesser of 14 days or 10%, you’ll have to allocate the deductions.
Tax Disadvantages
Just as property can appreciate in value, property values can also depreciate, and that can lead to being “under water” with the mortgage on the property. Also, just as we had positive cash flow, you could have negative cash flow when actual out-of-pocket expenses exceed the rental income. One of the key disadvantages of rental properties is that it often doesn’t provide you with current tax losses because those tax losses can be limited based on your income levels unless you are a real estate professional.
Currently, we have what is a called passive and active participation in real estate. If you do not actively participate in the management of the rental property, you are not allowed to write off any rental losses. Your losses build up from year to year until you have rental income or you sell the property. Only then can you take all of your losses. Active participants actively contribute in the management of the property. If your adjusted gross income (AGI) is less than $150,000, you can write off up to $25,000 of rental losses in one year. This income limit phases out to zero when AGI exceeds $150,000. Again, if you haven’t been able to write off all your losses, they accumulate and you will be able to take them when you sell the property.
Another tax disadvantage to rental property is depreciation recapture. This can cause a significant tax impact for people selling rental properties. Part of the gain will be taxed as capital gain at a maximum of 15% if it is long-term; however, the part of the gain related to depreciation is taxed at 25%. That’s federal, don’t forget your state tax, also.
At Henssler Financial we believe you should Live Ready, which includes understanding how your investments affect your taxes. Rental properties can be both your tax friend and enemy. You should consult with your tax adviser as to what’s right for you. If you have questions regarding the tax implications of your rental property, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
