Renting out residential property can be a great investment considering real estate market trends and favorable tax rules. Being able to take advantage of many tax deductions, which are not available for other types of investments, could make it even more lucrative. However, it can be stressful, challenging and involves additional financial obligations. Furthermore, there are a lot of tax rules that must be followed in order to report rental activity properly, and there are many deductions that can be overlooked.
So, what can you deduct?
Most know about deducting mortgage interest, insurance, property taxes, repairs and maintenance, association fees, utilities and so forth, but there is much more to be taken into account.
Besides mortgage interest, a landlord can deduct interest paid on other business related expenses, such as business loans taken to improve a rental property, car loan payments (but only the part used for business purposes), and the interest paid on credit cards used solely for business purposes.
Claim your home office
Sometimes we do not think about rental property as a regular business, but it is. If you have a room specifically dedicated for rental activities, you can deduct a portion of house expenses against rental income. A portion of deductible expenses can be calculated either by multiplying business percentage (the office’s square footage divided by the square footage of the entire house) by actual total expenses or using a standard rate allowed by the IRS: $5 per square foot with a maximum of 300 square feet.
Track your mileage and travel expenses
If you use personal vehicle for such rental activities as buying supplies, picking up rent or showing the property to potential renters, a portion of vehicle expenses is deductible. You can either deduct actual expenses based on business use percentage or apply standard mileage rate to total business miles driven during the year (there are some limitations on using standard mileage rate).
If you travel overnight for your rental activity, you can deduct airfare, hotel bills and meals. Remember to keep detailed and accurate records and supporting documentation to substantiate both automobile and travel expenses.
Improvement vs. Repairs
Beware that the IRS makes a distinction between improvement and repairs. Repairs and maintenance expenses are considered work that is necessary to keep your property “in good working condition” and can be fully deducted in the year they are incurred. On the other hand, improvements to the rental property should be capitalized and depreciated over its useful life. However, depreciation of the cost of residential building can be a nice benefit sheltering some of your cash flow from taxes. Generally, for something to be considered depreciable, it has to make your property either bigger, add significant value to a property or increase its useful life.
To maximize repair deduction, you can try to fix and restore, if possible, instead of replacing. A replacement is almost always an improvement for tax deduction purposes. For example, if the roof is damaged, do not replace the whole roof, repair or replace only the damaged part. Repairs are usually much cheaper than replacements, however, consider the fact that sometimes it makes more economic sense to replace and you may be able to charge more rent for a unit with new appliances, carpets, etc.
Passive Loss Rules
Generally, owning rental property is considered a passive activity. In short, it means that losses incurred are limited against other types of income. Passive losses in excess of passive income are suspended until you either have more passive income or you sell the property that produced the losses. This means that rental property loss deductions can be postponed, sometimes for many years. There are certain exceptions to this rule. First, if you are considered a real estate professional, rental real estate activities are not considered passive. Second, if you are considered actively involved in your rental activity, you can deduct up to $25,000 in passive rental losses if you make under $100,000.
Self-Employment Tax and High Income Medicare Surtax
More good news; rental income is not subject to self-employment tax, which applies to most other unincorporated profit-making ventures. However, according to a provision in the health care legislation, rental income and gain from the sale of investment real estate can be subject to new 3.8% Medicare surtax on net investment income.
When you sell
When you sell a property you have owned for more than one year, the profit is generally treated as a long-term capital gain. As such, it will be taxed at favorable rates. However, part of the gain—an amount equal to the cumulative depreciation deductions claimed for the property—may be subject to recapture rules and higher tax rates. Remember that you may also owe state income tax on real estate gains.
You also have the option of selling appreciated real estate on the installment plan. Then, your taxable gain can be spread over several years. Further, suspended passive losses can be used to shelter gains from selling appreciated properties.
On the other hand, it is important to remember that rental property appreciation is not taxed until you actually sell. Good properties can generate the kind of tax-deferred growth that investors dream about. Finally, so-called “like-kind exchanges,” also known as “Section 1031 exchanges,” allow real estate owners to unload appreciated properties while deferring the federal income tax. In short, you exchange the property you want to dispose of for another property. If you adhere to the like-kind exchange rules, you are allowed to defer paying taxes until you sell the replacement property.
As you can see, tax rules for landlords can be very favorable, even though they can become somewhat complicated depending on an individual situation.