MAY 2011: What You Need To Know About - Rental Real Estate Taxation
Author: Lew Wessel | Photographer: Photography by Anne
People gripe all the time about the complexity of the U.S. income tax system. Other than March Madness, it seems to be our favorite topic of conversation. But, despite the fantasies of the fair or flat taxers, our income tax system will always be extremely complex. Why? Because every time a tax law is passed, tens of thousands of extremely bright and creative tax lawyers, accountants and just plain tax experts start figuring out ways to circumvent it or at least blunt its impact. And, of course, for every ingenious tax-beating scheme they think up, the young bucks on the Congressional tax-writing committees, as well as the underpaid but very smart and eager attorneys at the U.S. Treasury and IRS, refine the tax law to squash that scheme. It’s a never ending cycle. Remember the Tax Simplification Act of 1986? This is affectionately known in accounting circles as the CPA Relief Act of 1986.
I bring this up as prelude to this month’s article on the taxation of rental properties. I can assure you the rules at the beginning were quite simple: figure out your net rental income and add it to your taxable income. But once those sharp tax lawyers began to play with what constitutes “net rental income,” all hell broke loose and we ended up where we are today. So, fasten your seatbelts…
Let me begin by repeating some basic advice: Never let the tax tail wag the investment dog. And dog is an appropriate term here, because if the real estate you’re contemplating buying as a pure rental or a partial rental/vacation home is a “dog,” your tax losses will somewhat mitigate your pain, but you’ll still suffer. That being said, here’s the basic tax deal with rental real estate:
Thanks to that aforementioned Tax Simplification Act of 1986 (“the ’86 Act”), real estate investments are now treated as “passive investments.” What that means is that if you make money from your real estate rental, you pay taxes on it now; but, if you lose money, you may not be able to deduct the loss until you actually sell the property. Like many tax issues, there is a different outcome for different taxpayers: If your income (actually “adjustable gross income” or AGI) is above $150,000, you can’t use your real estate losses to reduce your non-real estate income. If you make less than $150,000 AGI and you “materially participate” in managing the real estate property, you may be able to take up to $25,000 against your other income and reduce your overall current tax bill. What is materially participating to the IRS? If you’re finding your own renters, collecting the rent and making sure the property is cared for, you’re materially participating; if you never see the property and get a report once or twice a year from the rental agency, probably not.
So, of what does the tax gain or loss from a real estate rental consist? This is not complicated: rent less all the expenses related to generating the rent. The most common expenses are rental agency commissions, insurance, taxes, mortgage interest, maintenance, repairs and more. These are all out of pocket, real cash expenses. Fortunately, the tax law allows another non-cash expense: depreciation.
THE ART OF DEPRECIATION
Depreciation befuddles a lot of non-accountants, but it’s actually a very simple concept. In order to earn rent, you have to buy a house or condo. That is a legitimate deductible rental cost. However, that “cost”—the price of the rental property—will generate income for years and years. Quite reasonably, the cost should be spread over years and years and not taken in the first year (Note: accounting students learn this “matching concept” in 101). Fortunately, you don’t have to guess how long the “years and years” is for your rental property. Tax law dictates it at 27 and half years. Beware, though, that the land portion of your condo or house is never deductible (although landscaping is…whew).
So, let’s say you buy a rental condo for $300,000, and you determine that the land portion is $25,000 and the condo portion is $275,000. Dividing $275,000 by 27.5 gives you a depreciation deduction of $10,000 per year to add to your expenses. That means that even if you earned $10,000 after deducting all those real, out-of-pocket expenses like insurance and commissions, this $10,000 depreciation expense makes the taxable income from the property a very cool zero. Not bad!
An historical footnote: The accounting miracle of depreciation wiping out taxable income and even creating large losses was the basis for much of the “tax shelter” investing prior to the 1986 Act. When Reagan and Packwood and Rostenkowski decided to “simplify” things, real estate tax shelters became Enemy #1. Now, unless you are considered a real estate professional (a whole different topic), the ability to use real estate losses to offset other income is severely restricted.
When you eventually go to sell the property, there is good news and bad news. The good news is that when you sell your rental home, the gain will be taxed at long-term capital gains rates (since no one is “flipping” properties anymore, “long-term,” or ownership of more than one year seems like a safe bet). This rate is currently a maximum of 15 percent as compared to 35 percent for ordinary income like wages. The bad news is that the portion of the gain attributable to depreciation will be taxed as ordinary income. This is called “recapture.” For example, if you sell your $300,000 condo above for $350,000 after owning and renting it for five years. Assuming no other changes, the tax “cost” or basis of the property is now $250,000 ($300,000 less $50,000 (five years depreciation) and your total gain is thus $100,000 ($350,000 less $250,000). Of that gain, $50,000, or the amount you previously depreciated will be taxed as ordinary income and $50,000 as capital gain. Confusing, but it’s actually a fair result tax-wise. You were able to deduct the depreciation as ordinary income, so now you are just adding it back at the same rate. But what if you weren’t able to actually use the depreciation due to the loss limitations mentioned above? Surprising perhaps to you skeptics out there, but the tax code actually makes you “whole” by allowing the release of those losses without restrictions at the time of sale.
SO MUCH FOR THE EASY STUFF! WHAT ABOUT VACATION RENTAL PROPERTIES?
A vacation rental is simply a home that you rent out and use personally. As long as you keep your personal use of the property to less than 15 days or 10 percent of the total rental days, all is well and no special vacation rental rules apply. Furthermore, if you rent the home for 14 days or less, any income you get is totally, utterly tax free. There’s no other provision like this in the tax code, and it’s a real bonanza for the lucky few who own homes near once-a-year big event sites. Think of the lucky Sea Pines homeowner collecting a tax-free check from Jim Furyk for a one-week rental during the Heritage.
Once you surpass either of these time thresholds, you do come under the special vacation home rental rules. The most important element of these rules is that no loss can be recognized from the property, not even the $25,000 limit mentioned above. In addition, deductions against rental income have to be allocated between personal and rental use and deducted in a very specific order. This ordering requires interest, property taxes and casualty losses to be deducted first, followed by operating expenses such as rental commissions, the rental portion of utilities, repairs, etc. and then, finally, depreciation. The reason for this is that, in most cases, interest and taxes are already an allowable itemized deduction on Schedule A, so any use of them against vacation rental income is pretty much a waste. The countermeasure to this is to consider paying off your rental unit mortgage before paying off your home mortgage. This will free up some room to allow for operating expense deductions and depreciation. You also may want to consider allocating interest and taxes to the rental property based on calendar days rather than on the proportion of rental days to personal days. This Tax Court method will, again, send more of the interest and tax deductions to Schedule A and free up the other deductible items to be used against rental income. Be aware that this method is not preferred by the IRS, and your tax software will not likely choose it automatically.
KEEP GOOD RECORDS AND LEARN THE RULES
In this arena, more than most, good records are essential. Vacation rental taxation, with its mix of non-deductible personal use items and deductible rental items, is ripe for abuse. If you do get audited, you need to be well armed. There are many, many legitimate rental deductions to be recognized, including one or two visits a year to your property to assure it is in good shape. The key is to keep good records and to not be a “tax pig.” We all know what happens to pigs.
To get the most (or least) impact from the real estate rental tax rules, I encourage you to study up on them. IRS Publication 527, “Residential Rental Property” is the right place to start and, of course, your CPA can be very useful. The rules are such that if you learn them, you’ll find that your rental or vacation rental property is a very tax-friendly investment—maybe not the pure tax shelter of pre-1986, but not too shabby.
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