Owning rental real estate can be a good way of building wealth. Many millionaires built their fortunes through real estate investing. However, sometimes people get into the rental business because they are forced to. That is, they may want to sell their house, but the housing market is depressed and they can’t sell their house for more than what they owe or what they feel it is worth. So, they become “accidental” landlords and have to start dealing with tenants and more complex income tax preparation. This discussion is for people who have a rental property that is used 100% for rental, i.e. no personal use.
If you actively participate in real estate
rental, it’s generally considered a passive
activity. Active participation means that you own at least 10% of the property,
make management decisions like selecting tenants, or arranged for others to
provide services, like repairs. As a passive activity, deductions for losses
(expenses) are limited to the extent of rental income. So, if you have $12,000
of rental income for the year, you can only deduct up to $12,000 of rental
related expenses. And, it’s very easy
to have large expenses related to your rental property. If you still have a
mortgage on the rental, the interest is deductible along with depreciation,
real estate taxes, insurance, and any repairs that you may have to make
throughout the year. If your rental is vacant for a few months in the year,
income drops but expenses keep going. Generally, all income and expenses
related to rental real estate is reportable on Schedule E.
As I said,
generally rental expenses can only be deducted up to rental income. However,
there is a special allowance. If you
actively participate in a passive rental real estate activity, then you may be
able to deduct up to $25,000 of loss from the activity from your non-passive income. Non-passive income means ordinary income and
investment income. This is potentially a
huge benefit in that it can lower your overall income tax obligation. However, there is one downside…phase out. The
$25,000 exemption begins to phase-out if your modified adjusted gross income
(MAGI) is $100,000 and it disappears entirely if your MAGI is $150,000 or more.
If you have an
un-allowed loss because your MAGI is too high don’t worry, you can carry forward
that unused loss to future tax years, indefinitely. So, in the years where your net income is
positive you can still offset income by using prior years’ un-allowed losses.
You just have to remember to carry forward the loss until it is used up.
If you are new to
renting residential real estate you’ve probably heard about depreciation, but
don’t really understand it. Think of it as a way to recover most of the money
you spent purchasing and remodeling your home, spread over 27.5 years. You
cannot depreciate the cost of the land, only the house. But, the IRS allows you
to deduct an annual depreciation expense equal to your adjusted basis, divided by 27.5. There are several rules around depreciation,
too many to discuss here. But, depreciation is an important expense that you
should not ignore, so consult a tax pro like an Enrolled Agent if you are
having difficulty determining the depreciation deduction.
Congress has written tax laws that are very generous when you are renting for profit. However, the generosity disappears if you rent to a relative, or below fair market value.
If you rent to a relative, your rental property may be considered personal use, i.e. treated the same as a second home. In this case, you can still claim mortgage interest and real estate taxes, but they are reported on Schedule A, as itemized deductions.
If you rent below fair market value, the activity is considered "not for profit". Deductible expenses start to
disappear. You can still deduct rental
expenses, however only up to rental income.
The special $25,000 loss allowance is gone, and you cannot carry over
losses to future tax years. Rental expenses are claimed on Schedule A as
itemized deductions, subject to the 2% AGI limitation. Rental income is
reported on Line 21 of Form 1040.
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