Tax WISardry with Rental Properties

Rental real estate is a great tax shelter – one of the finest ways to save taxes — but the tax rules are surprising and can be harmful to your finances!  So if you are a landlord or are thinking about being one, watch out!

RENTAL PROPERTY TRAPS:

  • Your deductions can be mysteriously delayed.
  • When you sell a property, you can pay taxes on “phantom gain”  even though you receive little cash.
  • You can pay more than fifty cents in taxes on a dollar of income.

So what do you do? Get professional advice! As a former IRS attorney, I advise landlords how to pay the lowest legal taxes. I advise everyone from amateurs to real estate gurus with millions of dollars in real estate. I will give you a taste here.

DEDUCTING OPERATING COSTS

Let’s talk taxes! The IRS Schedule E is where you report income and deductions for a rental property (Beware of the passive activity rules, discussed below). You can deduct the cost of interest, taxes, and insurance for your rental property. “Points”, (prepaid interest) and loan closing costs are not deductible in the year borrowed. You can amortize these costs over their useful lives. Repairs are a major deduction but too large repairs are a favorite of IRS auditors because large repairs often amount to “capital expenditures,” which are discussed below. Deduct taxes, even back taxes, in the year paid. 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.

CAPITAL EXPENDITURES AND BASIS

When you invest in an asset that lasts more than one year, it is called a “capital expenditure. These assets include 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. When you sell your rental property, your gain equals the selling price of the property less its adjusted basis.

THE DEPRECIATION DEDUCTION

The depreciation deduction is pro rata deduction of the basis of an asset over its useful life. Depreciation is added to your operating costs so you can deduct more than you spend each year. For example, the IRS specifies a 27.5-year useful life for residential rental property (39.5 years for nonresidential properties) so you can deduct 3.6% of basis per year. The land is not depreciated.

GAIN OR LOSS

If you sell a property, you will have a 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 a long-term capital gain (LTCG), which qualifies for a tax rate of 20% or less. At present, a 3.8% additional tax applies to investment income where adjusted gross income exceeds $200,000 for singles or $250,000 for joint filers.

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.

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. On the other hand, you may avoid tax where you have again if the sale qualifies under special rules as a “like-kind exchange.” Give me a call if you suspect you may have a phantom gain. Read more.

RENTAL/PERSONAL PROPERTY

What about a property you use personally and rent, such as a vacation home? The tax rules in this situation are 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 personally use the property for more than the greater of 14 days or 10 percent of rental use, there are even more restrictions and complications. Some rental deductions are allowed and some are not.

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.

You can thread your way through the labyrinth with professional advice. Be sure to get that advice before you take an action that will get you in trouble.

About Wis Laughlin

I help clients with tax preparation and IRS representation, estate planning, and complex contracts, including LLC's. As a former IRS tax attorney in their National Office. Law.com picked Wis in 2017 and several prior years as one of the Top Tax and Estate Lawyers in Tennessee. I am your advocate, not your accountant. I don't tell you what you can't do. I show you how to do it.
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