As part of our Real Estate Broker licensing continuing education requirements, I recently attended a seminar conducted by a CPA that specializes in taxes and financial planning for Real Estate Brokers and Property Managers/Landlords. The following notes are items I thought might be of interest to you.
The notes below are not here to give you specific tax advice, rather, they are to give you ideas on out how to pencil out your return on investment in regard to taxes. You should your own tax adviser and/or tax authority to verify the information provided is correct specific to your circumstances and to verify that there weren’t misconceptions on my part or changes to IRS rules.
How rental taxes are calculated and reported:
Rental income is reported on your federal 1040 line 17 which is computed by filling out schedule E. Here is the 2016 version. The income computed does not go on schedule C (for those of us who are self-employed). The majority of schedule E is pretty straightforward: you can deduct cleaning, maintenance, insurance, legal/professional fees, mortgage interest, repairs, taxes, utilities, etc.
Notes on depreciation:
One of the areas of confusion that you should pay close attention to in your deductions is the depreciation deduction. Depreciation essentially means that you can deduct a portion of the building cost each year that you place the rental in service. Only the cost of the building is what is depreciable – the land never “depreciates” in the sense that it doesn’t deteriorate like a building. The deduction is computed by taking 1/27.5 of the building cost per year (for more info see the IRS depreciation page). The CPA said that the way that he computes the building depreciation cost is by looking at the tax record and figuring out the ratio of building cost/land. Though the tax record value is usually smaller than what the property is purchased for, it is useful in computing the ratio for depreciation. So for example, if the tax record says that the value if the land is $100,000, the value of the building is $200,000 for a total of $300,000 in value, you take $200,000 and divide it by $300,000 to give you a ratio of 66.67%. If you actually purchased the building for $400,000, multiply $400,000 by .6667 to come to a figure of $266,680, then divide by 27.5 to come to a final depreciation deduction of $9697, which you can take each year until you recover your cost basis or when you sell.
One of the biggest deduction mistakes that people make is not taking the depreciation each year. This is because, regardless if you took the deduction or not, the depreciation is supposed to be recaptured when you sell the home. So say that you rented the above $400,000 property each year for for 5 years. Your depreciation recapture scenario would look like this: $9,697 x 5 = $48,485. If you are taxed at 25% fed and 9% state, you’ll owe $16,485, on top of your capitol gains (unless of course you are doing a 1031 tax-deferred exchange when you sell, but you will still pay the recapture tax when you sell outside a 1031 in the future).
Important notes on loss limitations:
Many times, especially in the beginning of the investment years, all of the deductions (particularly the depreciation) adds up to being able to report a loss on your 1040, which can significantly reduce your tax burden in the current year. However, another big mistake that Realtors and other industry professionals don’t realize is that there are pretty large limitations to the losses that you can take. If your AGI on line 37 is over $150,000, you don’t get to take a loss. The passive activity losses are incremental on down to $100,000 of AGI. Passive activity loss limitations are computed using form 8582.
The one big exception to the passive activity loss rule: if you are a Realtor or related business professional. An excerpt of the current IRS code: “Generally, rental activities are passive activities even if you materially participated in them. However, if you qualified as a real estate professional, rental real estate activities in which you materially participated aren’t passive activities. For this purpose, each interest you have in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity. See the Instructions for Schedule E (Form 1040), Supplemental Income and Loss, for information about making this choice.” This exception can be found on the IRS passive activity loss page.
Improvements or repairs: deductible or depreciable?
Another area of confusion and misconception is figuring out if an expense is an improvement or a repair. Repairs, generally, are considered deductible in the year that you paid for them. However, if you’ve put an addition on the home, renovated it, etc., those could be considered “improvements” for tax purposes, and need to be depreciated over the time period that the IRS allows, which differs depending on the improvement. Improvements may also be added to the cost basis of the home. These rules are pretty complex, and more discussion on the distinction between the rules can be found here. The improvements may also be added to the cost basis of the home (reducing capitol gains).
Notes on attempting to avoid capitol gains tax treatment:
It is very common, though not lawful, to try to avoid capitol gains taxes by moving into or making it appear that you have moved back into a previously used rental for two years prior to selling it. Though this is common, the IRS will sometimes scrutinize the records, looking at: utility bills, voter registration, DMV change of address, etc., to try to verify that you’ve actually moved into the rental.
In addition, normally when you live in the home for 2 out of the last 5 years, you are able to avoid capitol gains taxes. However, when converting to or from a rental, the rules get very complex and not always tax free. For 2016, you can get partially reduced tax free treatment based on the number of months rented after 2008 and dividing by the number of months owned. This concept is confusing and you’ll want to plan carefully if this is part of your tax strategy.
-It is recommended when you purchase a rental to ask the seller for a copy of their schedule E.
-If you’re purchasing a rental you may wish to use an LLC and/or take out an umbrella insurance policy.
-Be careful not to think of depreciation as “tax savings” since depreciation is something you will have to recapture when the home is sold.
I hope this helps point you in directions that help answer some of your investment questions!