A lot of us end up with Rental Real Estate throughout our career. It is the natural result of numerous PCS moves. There are a lot of tax considerations when it comes to rental real estate. So…since it is tax season I thought I would cover some of them.
Renting the Property. Once you turn a piece of real estate into a rental a bunch of tax “benefits” become available. Some of the major ones are:
Expense Deductions. You can deduct any expenses you incur for the production of income at the property. Normal expenses include: Repairs, Maintenance and Cleaning, Advertising, Management Fees, Mortgage Interest and Commissions. These expenses can be used to offset income in the year they occur (normally).
Depreciation Deductions. Normally things wear out. The IRS allows you to account for this through depreciation. You depreciate the structure (house) over 27.5 years. So each year, you’ll be able to deduct just under 4% of the value of the structure(s). A couple of notes. First, depreciation is not really optional. You must depreciate the property. Second, the value used for the depreciation is the Fair Market Value of the property when purchased or placed in service as a rental…whichever is lower. If you make improvements to the structure, such as a new roof, you do not expense them in the year acquired, but rather depreciate the improvements over the life of the improvement (could be less than 27.5 years).
Taking Deductions on Your Taxes. You may be able to deduct up to $25,000 in losses on your rental property against your other current income. To do this, you must Actively Participate in the management of the property. The IRS has specific criteria to determine if you actively participate. If you don’t actively participate in the management then your losses are passive and can only be deducted against passive income. If your Adjusted Gross Income exceeds $150,000 even if you actively participate in the management of the property you can’t take the deductions. Any deductions that you can’t claim on your taxes in the current year roll forward until you sell the property.
Selling the property. Just like when you rent the property there are tax issues, there are also tax issues when you sell it.
Depreciation Recapture. When you depreciate a piece of property, you are in effect saying it is wearing out and not worth as much. When you then turn around and sell it at more than what you said it was worth, the IRS says, “Wait a minute.” If you sell your property at more than it’s adjusted basis (FMV + Improvements – Depreciation) then the IRS wants the depreciation back. Any amount from the adjusted basis to the FMV when placed in service is what is called 1250 gains. 1250 gains are normally taxed at 25%. You can’t avoid depreciation recapture by refusing to depreciate the property. 1250 gains are due on the deprecation taken or that should have been taken.
Capital Gains. If you sell the property for more than its FMV when placed on the market you will owe capital gains taxes. Depending on how long you owned the property the gains will be either short-term or long-term. The gains will be taxed at your appropriate capital gains tax rate. If the property was worth less than its purchase price when placed in service, sales between the FMV and the original purchase price are generally not considered gains (this could apply if you lived in the house before it became a rental).
Primary Residence Exclusion. If the house still qualifies as a primary residence (you lived in it for 2 of the last 5 years …or up to 15 years if still on active duty), you will not have to pay taxes on the capital gains. You will however have to pay taxes on the Depreciation Recapture.
1031 Exchange. If you exchange the rental property for another rental property you can avoid current taxation. 1031 exchanges are a little complicated and you will need to hire a trustee to hold the money, if you sell the house. But, they can be done.
Real Estate is one of the last great tax shelters. Even if you can’t deduct current losses, you can shelter income from taxation…which can be a great benefit. While direct ownership of real estate is not for everyone if you do decide to own real estate or if you are forced to by a PCS, you want to make sure you understand the tax implications…or get help from someone who does.
Amat Victoria Curam 