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Understanding the Tax Ramifications of Investing in Rental Real Estate

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real estate accounting

Investing in residential rental properties raises various tax issues that can be somewhat confusing. Some of the more important issues rental property investors will want to be aware of are discussed below. At Haque CPA, our firm is adept in real estate accounting and can offer industry-specific services to you.

Rental Losses

Currently, the owner of a residential rental property may depreciate the building over a 27½-year period. For example, a property acquired for $200,000 could generate a depreciation deduction of as much as $7,273 per year. Additional depreciation deductions may be available for furnishings provided with the rental property. When large depreciation deductions are added to other rental expenses, it’s not uncommon for a rental activity to generate a tax loss. The question then becomes whether that loss is deductible.

$25,000 Loss Limitation

The tax law generally treats real estate rental losses as “passive” and therefore available only for offsetting any passive income an individual taxpayer may have. However, a limited exception is available where an individual owns at least a 10% ownership interest in the property and “actively participates” in the rental activity. In this situation, up to $25,000 of passive rental losses may be used to offset nonpassive income, such as wages from a job. (The $25,000 loss allowance phases out with modified adjusted gross income between $100,000 and $150,000.) Passive activity losses that are not currently deductible are carried forward to future tax years.

What constitutes active participation? The IRS describes it as “participating in making management decisions or arranging for others to provide services (such as repairs) in a significant and bona fide sense.” Examples provided by the IRS of management decisions include approving tenants and deciding on rental terms.

Selling the Property

Gain realized on the sale of residential rental property held for investment is generally taxed as capital gain. If the gain is long term, it is taxed at a favorable capital gains rate. However, the IRS requires that any allowable depreciation be “recaptured” and taxed at a 25% maximum rate rather than the 15% (or 20%) long-term capital gains rate that generally applies.

Exclusion of Gain

The tax law has a generous exclusion for gain from the sale of a principal residence. Generally, taxpayers may exclude up to $250,000 ($500,000 for certain joint filers) of their gain, provided they have owned and used the property as a principal residence for two out of the five years preceding the sale.

After the exclusion was enacted, some landlords moved into their properties and established the properties as their principal residences to make use of the home sale exclusion. However, Congress subsequently changed the rules for sales completed after 2008. Under the current rules, gain will be taxable to the extent the property was not used as the taxpayer’s principal residence after 2008.

This rule can be a trap for the unwary. For example, a couple might buy a vacation home and rent the property out to help finance the purchase. Later, upon retirement, the couple may turn the vacation home into their principal residence. If the home is subsequently sold, all or part of any gain on the sale could be taxable under the above-described rule.

To learn more about taxes and rental property, give us a call today at 212-880-2617. Our staff of professionals are always happy to help. You can also request a free consultation online.

Are There Tax Advantages to Owning a Second Home?

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Are There Advantages to Owning a Second Home?

Whatever the location, size, or value of a second home, certain tax advantages are built in. However, your opportunity to benefit from them depends on how you use the property.

Personal Use

Both property taxes and mortgage interest are as deductible for a second home as they are for your primary residence — and are subject to the same limitations. If you file a joint return, you cannot deduct interest on more than $1 million of acquisition debt ($500,000 for married persons filing separately) on one or two homes.

Two tax advantages of home ownership are not available for a second home — the immediate deduction of mortgage points when purchasing and the capital gain exemption when selling. Both tax breaks require the home to be your “principal residence.” However, you can deduct the points on your second home’s mortgage over the loan’s term.

Rental Use

More tax advantages become available if you forgo some of your personal use in favor of renting out your second home for part of the year. But there may be drawbacks as well.

If you rent out your home for 14 or fewer days during the year, you do not have to report rental income on your tax return, regardless of the amount, and there is no effect on your mortgage interest deduction. But you cannot deduct any rental expenses.

If you rent out your property for more than 14 days during the year, all rental income becomes taxable from day one. However, rental-related ownership expenses — including depreciation, maintenance, and utilities — become tax deductible. Your personal use of the second home affects the deductible amount. When personal use is more than 14 days (or 10% of the number of days your home is rented, whichever is greater), the maximum deduction is 100% of the rental income. Note that allowing relatives to use your vacation home usually counts as personal use, regardless of how much they pay for the privilege. And, if a friend rents your home for less than the fair market rate, that also counts as personal use.

If your vacation home qualifies as a rental property (i.e., personal use doesn’t exceed the allowable limits), a deduction is allowed only for mortgage interest allocated to rental use. That could be important. If you were to rent your second home during July only, for example, then only 1/12 of your interest expense would be deductible.

Deducting Losses

What if your rental expenses exceed the rent you collect? Only an “active” investor can deduct rental losses. If you actively participate in managing the rentals and maintaining the property, you can apply up to $25,000 of losses each year against your regular income. This loss deduction is phased out for taxpayers with adjusted gross income between $100,000 and $150,000. But, if you hire a manager, you become a passive investor and can use rental expenses to offset only rental income. However, you can carry any excess deductions forward to future tax years.

Your use determines the tax treatment of a second home. Before you decide to rent your second home for more than 14 days a year, carefully weigh the benefits and disadvantages.

Deductible Yacht and Motor Home Financing

Your second home doesn’t have to sit on a fixed foundation to qualify for tax advantages.

According to the IRS, a facility qualifies as a residence if it has sleeping, cooking, and bathroom accommodations. Therefore, your yacht or smaller boat can be a second home. So can a motor home of any size or value.

Provided the boat or motor home secures the purchase loan, your mortgage interest is as deductible as it would be on a more conventional second home. The same $1 million limit on total debt to buy or improve your residences also applies.

For more help with individual or business taxes, connect with us today by requesting a free initial consultation. Our team can help you with all your tax issues, large and small.