Sure you want to be a landlord? We’ve all heard stories about challenging experiences with tenants — like those who took almost every fixture when they moved out, including curtain rods, towel bars and carpet. The disadvantages of owning rentals are offset, though, by real estate appreciation and tax rules that aren’t available for other types of investments. In fact, tax rules constitute a big reason so many fortunes are made in real estate.
I’m sure you already know you can deduct mortgage interest and real estate taxes on rental properties. You’re also able to write off utilities, commissions paid to rental agents, legal and accounting fees, insurance, repairs and maintenance, yard care and homeowner association dues. In addition, you can depreciate the cost of a residential building over 27.5 years. Say your rental property — not including land — cost $200,000. The annual depreciation deduction would be $7,273, which means if you don’t have debt on the property, you could have that much in positive cash flow without owing any income taxes. This is a nice benefit, especially if you own several properties. Commercial building are depreciated over a 39-year period.
Things get a little more complicated if your rental property creates a tax loss —and most do. When you have this situation, passive activity loss rules usually apply. In general, passive activity rules only allow you to deduct passive losses to the extent you have passive income from other sources. These other sources could be income from another rental property or a gain on the sale of rental property. Without passive income, your rental losses become suspended losses you can’t deduct until you have sufficient passive income in a future year or dispose of the property to an unrelated party. In some cases, you might not be able to deduct these losses for years.
There are two exceptions to passive loss rules.
Property owners with a modified adjusted gross income of $100,000 or less may deduct up to $25,000 in rental real estate losses per year if they “actively participate” in the rental activity — they’re involved in meaningful management decisions and have more than a 10 percent ownership interest. This annual loss allowance is phased when modified adjusted gross income tops $100,000 and is eliminated when income exceeds $150,000.
The other exception to passive activity loss rules applies to real estate professionals. Landlords who qualify as real estate professionals may deduct any amount of losses as ordinary trade or business income. To be considered a real estate professional, you must spend more than half your work time in real property trades or businesses in which you materially participate and spend more than 750 hours of service during the year in real property trades or businesses in which you materially participate. People with full-time jobs outside of real estate generally don’t qualify.
Eventually, your rent income will surpass your deductible expenses and your properties will generate taxable income instead of losses. You must pay income taxes on profits. But if you had suspended passive losses in earlier years, you can use them to offset profits. Another benefit is profit from rental real estate isn’t hit with self-employment tax, which applies to most other unincorporated profit-making ventures. The self-employment tax rate can reach 15.3 percent. Due to a provision in 2010 health care legislation, passive income from rental real estate can get hit with an additional 3.8 percent Medicare surtax. This doesn’t apply to real estate professionals and usually only hits upper-income levels.
When you sell a property you’ve owned for more than a year, the profit — the difference between the net sales proceeds and tax basis of the property after subtracting depreciation deductions — is generally treated as long-term capital gain. That means it will be taxed at a federal rate of no more than
20 percent (or 23.8 percent if you owe the 3.8 percent Medicare surtax). However, part of the gain — an amount equal to the depreciation that’s been claimed as deductions — is subject to your ordinary income rate. It’s important to remember rental property appreciation isn’t taxed until you actually sell it. Good investment properties can generate the kind of tax-deferred growth investors dream about.
You also have the option of selling appreciated real estate on an installment plan by taking a note for part of the sales price. Then your taxable gain can be spread over several years. You also can charge the buyer interest on the deferred payment. Remember those suspended passive losses we talked about earlier? You can use them to shelter gains from selling appreciated property.
Finally, tax law allows real estate owners to sell appreciated properties while deferring the federal income tax hit. These types of transactions are called like-kind exchanges and are also known as Section 1031 exchanges. With a like-kind exchange, you swap the property you want to sell for a replacement property. You’re allowed to “put off” paying taxes until you sell the replacement property. Be aware, though: There are strict requirements on the proper structure of a 1031 exchange.
All things considered, the tax rules for landlords are pretty favorable. But like with anything else, many factors should be considered before jumping into the rental market. Talk with your tax advisor to make sure owning a rental property is the best investment for you.