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Congratulations! You’ve taken the big step and bought your first rental property. Now all you need is a property manager, contractor, lender and real estate agent, and of course, tenants, and you’ll be on your way to amassing rental income.
You’ll also need to maintain an accounting of your rental activity for your tax return. Tax laws relating to rental properties are intricate and complex, and knowing what strategies to implement will go a long way to helping ensure your rental income translates into bottom line profits.
Passive Activity
Rental properties frequently produce a net loss for tax purposes due to depreciation and other operating expenses. As rental income is generally considered passive, losses are also treated as passive.
Passive losses generally are only allowed as offsets to passive income—that is, income from other rental properties or another business in which you do not materially participate. If passive losses exceed your passive income, they are suspended and carried forward indefinitely until they can be used to offset passive income or the proceeds of the sale of a rental property.
On the other hand, if you materially participate in your rental activity, you can deduct up to $25,000 in passive losses against your ordinary income, as long as your modified adjusted gross income (MAGI) is $100,000 or less. This deduction is phased out, or reduced, by one dollar for every two dollars of MAGI above $100,000; at $150,000 of MAGI, no passive losses are deductible. At that point, your losses are suspended and carried forward.
There are seven tests that the IRS uses to determine if you materially participate in a rental property. These tests set a threshold that the taxpayer must meet, using hours of participation, to qualify as a material participation. You are only required to meet one of these tests. To understand how to establish ‘Material Participation’ for tax purposes, visit the IRS website.
Deductible expenses
The deductibility of rental expenses will also depend on when your rental is placed into service. In general, the placed in-service date for rental properties will be when the properties are ready for full operational use and when you have offered it to the public for rent. Costs incurred prior to the placed-in-service date are generally capitalized and depreciated over 27.5 or 39 years (See Depreciation), whereas costs incurred after the placed-in-service date may be deductible in full in the current year. Examples of typical rental expenses are listed on the chart below:
| Examples of Rental Expenses |
|---|
| Cleaning |
| Depreciation |
| Homeowner Fees |
| Insurance |
| Mortgage Interest (not the principal payment) |
| Professional Fees (Legal and Accounting) |
| Property Management Fees |
| Real Estate Taxes |
| Realtor Commissions |
| Repairs and Maintenance |
| Utilities |
Calculating building and land basis
Because land cannot be depreciated, you need to allocate the original purchase price between land and building. The property tax assessor’s values are commonly used to determine the land allocation and compute the value of the building. A property tax assessed value is typically lower than the property’s fair market value.
Example A:
The taxpayer bought a residential rental property for $183,333. The property tax statement shows:
| Building | $120,000 | 75% |
| Land | $40,000 | 25% |
| Total Value | $160,000 | 100% |
To calculate the building and land basis, multiply the purchase price ($183,333) by 25 percent to calculate the land basis as $45,833. Multiply the purchase price ($183,333) by 75 percent to calculate the building basis as $137,500.
Depreciation
The depreciation of a property for tax purpose is based on its cost basis, that is, the purchase price of the property reduced by the value of the land.
Rental properties are classified as either residential or non-residential. Residential properties and improvements are depreciated over 27.5 years while non-residential properties and improvements are depreciated over 39 years using the straight-line method for tax purposes.
Example B: To expand on example A, the calculation to depreciate the residential rental property is its cost basis divided by 27.5 ($137,500/27.5 = $5,000). The annual depreciation amount is $5,000, which you can apply to your expenses each full year you rent the property.
Qualified business income deduction
Under the qualified business income deduction (QBID), a provision in the Tax Cuts and Jobs Act of 2017, you can deduct 20 percent of net income from a qualified business from your taxable income. The deduction applies mainly to businesses, but if a real estate investor has regular and continuous activity with their rental property, the activity can rise to the level of a trade or business and qualify for the QBI deduction.
Real estate owners who are eligible for QBID and who have taxable income of less than $160,70 ($321,400 if married filing jointly) can deduct 20 percent of their qualified business income. For example, if your income is a combination of net rental income of $100,000 and W-2 wages of $50,000, you would be able to deduct $20,000 from your net operating income.
For taxpayers with taxable incomes above $160,700 ($321,400 if married filing jointly), the deduction can be limited to W-2 wages or 2 percent of the unadjusted basis immediately after acquisition (UBIA) of qualified property. Using the QBI deduction to reduce your tax liability can be complicated. Consult your CPA to ensure you are taking advantage of the current tax law.
Conclusion
Renting a property is a business. You will have to report the income you earn when you file your tax return each year. The tax rules for rental properties are complicated.
In part 2 of our rental series, we will discuss the sale of your rental property.
To learn more about the taxation of rental properties, contact your HBK tax advisor.
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