Real estate rental properties can be a satisfying way to build retirement income and a fine tax shelter. However, if you are a landlord or are thinking about being one, watch out for tax traps. For example:
RENTAL PROPERTY TRAPS:
- Your deductions can be delayed.
- When you sell a property, you can pay taxes on “phantom gain” even though you receive little cash.
- In some cases you may pay more than fifty cents in taxes on a dollar of income.
So what do you do? Get advice from a former IRS attorney — me! I can show you how to get the most value out of your rental properties. I advise everyone from newbies to real estate gurus with millions of dollars in real estate. Get a taste of my thinking here. Make a free, half hour appointment to find out more.
DEDUCTING OPERATING COSTS
Let’s talk about taxes! The IRS Schedule E is where you report income and deductions for a rental property. You can deduct all “ordinary and necessary expenses.” For maximum tax savings you must recognize and record all deductions.
Typical deductions are listed on the Schedule E and include: ♦ advertising, ♦ local auto travel, ♦ cleaning and maintenance, ♦ commissions, ♦ premises and mortgage insurance ♦ mortgage interest, ♦ legal and professional fees, ♦ management fees, ♦repairs, ♦ supplies, ♦ real estate taxes, ♦ insurance, ♦legal and professional fees, ♦ management fees, ♦ amortization of points and loan closing costs.
Less obvious deductions include ♦Airbnb fees, ♦ state and local government occupancy taxes, ♦ sales taxes, ♦ pest control, ♦ cable, ♦ depreciation of the building and contents, ♦ business education and travel to get it, ♦ cost of running your management office, including a ♦ home office, ♦ equipment, ♦ postage etc.
I can guide you to many other deductions depending on the particular property, such as association fees, security monitoring, and transportation costs. I use checklists of rental deductions, to make sure that nothing is missed.
My advice: Beware of large repair deductions. These are a favorite target of IRS Auditors because large repairs often constitute capital expenditures.
CAPITAL EXPENDITURES AND BASIS
Capital expenditures are costs of assets with a useful life of more than one year, such as the building, a new roof or air conditioning unit.
The basis of your rental property includes certain closing costs, plus the cost of improvements. The “adjusted basis” of the property is basis reduced by prior depreciation deductions. Basis is used for calculating the depreciation deduction and gain or loss on the sale of an asset.
THE DEPRECIATION DEDUCTION
The depreciation deduction is pro rata deduction of the basis of an asset over its useful life. Added to your operating costs, depreciation allows you to deduct more than you spend each year. For example, the IRS specifies a 27.5 year useful life for residential rental property, so you can deduct 3.636% per year. Nonresidential property has a 39 year life – 2.564% per year. Land is not depreciated.
Some “components” of your property, such as appliances, may qualify for much higher depreciation than a building.
GAIN OR LOSS
If you sell a property, you will have taxable gain if its selling price exceeds its adjusted basis. If you hold a property for 12 months or more, the gain on the sale is long-term capital gain (LTCG), which qualifies for a much lower tax rate. High income taxpayers may pay an additional 3.8% tax on such gain.
“Phantom gain.” occurs where a property’s adjusted basis has been decreased by depreciation or where you refinanced and took out cash.
Loss of capital gain trap: A property held primarily for sale does not qualify for capital gain treatment. So a real estate flipper, who is in the business of buying and selling properties, may not qualify.
Special rules must be strictly followed for the sale to qualify as a “like kind exchange rules.” Get professional advice to qualify.
DEALER TRAP: A property held primarily for sale does not qualify for long-term capital gain treatment. So a real estate dealer, who is in the business of buying and selling properties, may not qualify. Flippers get caught by this trap
“Phantom gain” is a taxable gain that occurs even though you have no equity because the property’s adjusted basis was decreased by depreciation or where you previously refinanced and took out cash.
What about property you use personally and rent, such as a vacation home? This situation is complicated. You must divide all deductions between personal and rental use. The IRS and the courts disagree on how. Furthermore, in a year when you use the property for more than the greater of 14 days or 10 percent of rental use, there are even more restrictions.
TIP: Sometimes, vacation homes provide more tax benefits if you treat them as second homes, rather than rental properties
PASSIVE LOSS RULES
Congress enacted the Passive Activity Loss rules (PAL) to fight tax shelters, and the PAL rules automatically apply to most rental activities. You must suspend these losses until there is offsetting income from PAL’s or you sell the property producing the loss. However, a taxpayer may immediately deduct up to $25,000 of PAL from rental activities in which he actively participates. Active participation means performing significant, bona fide management functions. Using a property manager does not automatically disqualify you.
The $25,000 limit on allowed losses is reduced by 50¢ for every dollar by which modified adjusted gross income exceeds $100,000. So at $150,000 in MAGI you deduct nothing. Married taxpayers filing separate returns may not use the $25,000 allowance unless they live apart during the entire taxable year.
REAL ESTATE PROS
If you spend most of your working time in the real estate business, rental real estate losses are exempt from the passive loss rules. However, to be a real estate pro, a person must spend a majority of work hours and more than 750 hours per year in real estate activities. Mortgage brokerage and loan origination services aren’t real property businesses for this purpose. (Hickam, TC Summ. Op. 2017-66).
Tax Reform Benefits
“Qualifying trades or businesses” (not “C corporations”) such as partnerships, S corporations, or sole proprietorships can deduct up to 20% of profits from their taxable income. However, certain limitations phase in after a single taxpayer’s taxable income exceeds $227,500 or a joint filer’s exceeds $415,000. The operation of a rental property is not automatically a qualifying trade or business, but it should qualify if it involves regular, continuous and substantial activities that have the objective of making a profit. But watch out! f the operation of a rental property involves significant services and substantial costs, it is likely to be a trade or business.
Wis’ Tax Mastery© program generates a personal tax plan for each client that focuses on that client’s best tax strategies,to give the lowest legal taxes.