The Basics (to the Nitty Gritty) of Rental Tax Ramifications

By: Lee Grubb, Grubb's Tax Service

Those involved with real estate, such as property managers and realtors, are often asked about the tax aspects of owning or selling rental real estate. In many cases, they have to fall back on advising their clients to receive information from their CPA/EA/Tax preparer. 

It’s not that they don't want to tell you; the subject is somewhat complicated with ever-changing rules. Rentals are handled on Schedule E of the income tax return and usually a depreciation schedule.

To best help you navigate information about taxes relating to rental properties, let's start with some definitions:

Definitions

Residential Rental Real Estate- Think single family residences, duplexes, structures with four or fewer living units, single apartments, condo's, mobile home, boats (if fully self-contained), and Air BnB type rentals.

Commercial Rental Real Estate- This would be apartment buildings with more than four units, commercial buildings (warehouse, mall, restaurant, etc.), and raw land.  Be cautious, because law may determine what is commercial and what is residential.

Vacation homes- This is where you partially occupy the rental at some time during the calendar year. Rules for this can be complex depending on how many days you use it, and how many days it is rented out. 

When a Rental is Not a Rental- If your personal residence is rented for 14 days or less during the calendar year, you do not have to report the income on your tax return.  Ask anyone who has rented their homes during the Coachella Music Festival or Burning Man on just how lucrative that can be.

Depreciation- When a building (such as a house) is put into service as a rental, you get a piece of the value of the building as a deduction against the income. For residental, this is generally 1/27.5^th of the building value. For commercial properties, this is generally 1/39^th of the value, each year until the building value has been fully written off. Land is never depreciated.

Depreciation reduces the house value of the property for determining gain when you sell the property. Depreciation must be taken into account. It is not optional. As the IRS says, even if you did not take the depreciation into account, you have to figure gain in a property as though you did take it when you sell it.

Improvement vs Expense- Improvement is depreciated over time as a write off. An expense is used as a write off during the year the money is spent on it. 

Example – If you fix your roof to repair a leak, it is an expense. If you completely reroof, it is an improvement that will get depreciated over time. If you fix up a bathroom by making repairs and remodeling it, it is an improvement.  There are 3 important safe harbor elections for defining repairs to also consider, below:

1. De minimis Safe Harbor - This can include any expense under $2,500, but item can’t be part of a larger item. For example, you can't break down your new HVAC into its parts to expense it.  Make sure you get itemized receipts when using this.  You will need to attach statements to your return (a.).

2. Routine Maintenance Safe Harbor - May deduct in the year it occurred as an expense, no matter how expensive. It must be a repair for maintenance that is expected to be done again in less than ten years, and can’t better the property. It is a method of accounting for expenses instead of an attachment to qualify for the safe harbor.

3. Rental Business Size Safe Harbor – This allows landlords to currently deduct on Schedule E, all annual expenses for repairs, maintenance, improvements, and other costs for a rental building. Limitations on use:

1. Basis of $1,000,000 or less excluding land and land improvements.
   
2. Annual expenses for repairs, maintenance, and improvements, cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis (basically the original cost plus any improvements without deducting depreciation).
   
   
3. Annual gross income for the landlord must be less than $10 Million for the three preceding tax years. Must attach a statement to your return each year to elect (b.).

Real Estate Professional- A taxpayer will be considered a real estate professional if more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates. They will also be considered a real estate professional if the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

Now that we have those out of the way...

Rental Real Estate profit and loss:  Take rent collected for the year then subtract expenses and depreciation to arrive at your net profit or loss. Expenses are everything you spent on it out of pocket during the year such as repairs, property taxes, HOA fees, insurance, advertising, utilities, and even property management/Air BnB type fees.

If the net of the rental is a loss:  As an individual (no matter if married filing a joint tax return or a single return), if the Modified Adjusted Gross Income MAGI(c.) is under $100,000, or $50,000 for Married Filing Separate, you may get to deduct up to $25,000 of the loss on your tax return that year if actively participating (this would include making the decisions on the property, even if it is professionally managed).

If the MAGI is between $100,000 and $150,000, the $25,000 loss max is adjusted down a sliding scale.  Any losses not able to be taken in the year are rolled over to the next year to possibly be used. They will continue to be rolled if unable to be used in each year, due to the above limitations, until the property becomes profitable or the property is sold where all the accumulated loss is released to use on the tax returns. 

Real Estate Professionals do not have a limit on their losses they can use.  Rentals held in a passthrough entity such as a Partnership or S-Corp have different rules on passing losses.  Rentals held in Living Trusts that are still revocable are treated the same as an individual. Rentals held in a Trust that is irrevocable may (under certain circumstances) be able to pass income, minus expenses and depreciation, out separately to a beneficiary to create a loss on the beneficiaries’ income tax return. Otherwise, the loss stays balled up in the Trust to be used in future years.

If the net of the rental is a gain, it will be taxed as ordinary income.  It does not get a long-term capital gains reduced tax rate, nor is it self-employment.  It is considered “business income” for the purposes of the Qualified Business Income Deduction (QBID). QBID is a special deduction you get for certain business profits, under certain income conditions. It is not part of itemized deductions so you can get it even if not itemizing.

The rules for QBID can be very complicated. Generally, if your taxable income (income after all your deductions aside from QBID) is under $329,800 married filing joint, and $164,900 for all other filing statuses, you will get a deduction of 20% of the net rental income on the tax return.

Security deposits can be treated as income and then any given back as a deduction the year the renter leaves or not be considered income in the year received but any used to pay for damages will be considered income in the year the renter leaves.

Vacation Rental: Generally, the rules for vacation rentals can be very confusing and complicated. It depends on the number of days you use the property and the number of days rented out. Too many days used personally and you can only offset the income, there is no loss allowed. There is no loss on Schedule E as a rental. 

If you rent the property for less than 14 days, you do not have to claim the income on your return (nor do you get any expenses).  So, if you rent the property more than 14 days and occupy it more than 10% of the number of days rented out, vacation rules apply and you are limited to the expenses to offset the income. However, you can take the mortgage interest and property taxes prorated personal portion as a second home on Itemized deductions (Schedule A) if you have no other 2^nd home.

If you already have a second home, these personal expenses would not be able to be used on the return. Generally, there are nuances and ordering rules for expenses that may be able to get you more write-off than the above. If you think you have a vacation rental situation, you will have to consult a tax professional.

Sale of a Rental: The net profit on the sale of a rental=

Sale Price – buy price – sales costs – cost to fix up for sale + cumulative depreciation = Net Profit

The amount of depreciation that was or could have been taken as an expense over the years comes back as part of the sale calculation.  Under most circumstances, the depreciation part of the sale Net Profit is taxed at a flat 25%, while the rest of the profit is long-term capital gains ( if a rental longer than a year) with lower tax rates. This can possibly trigger extra investment taxes of 3.8%, past certain income levels. Any rental loss that was still being carried is released on Schedule E when the property is sold and used to offset income.

Selling Rental as a Personal Residence to Shelter Gain:  You can sell a rental as a personal residence under certain conditions.  From the date of the sale of the rental, if you look back five years, and you have occupied and owned the property at least two years out that five year window, it can be sold as a personal residence and shelter up to $500,000 of gain ($250,000 if filing single or married filing separate).

There might be some tax on some of the cumulative depreciation depending on the circumstances.  This has been used by some who move to a new location and don't want to sell their previous home right away. They could rent it out for almost three years and still sell as a personal residence with max $500,000 of gain exclusion.

This strategy of selling a rental as a personal residence could also be used to reduce taxable gain in a rental that has a lot of gain in it. You could move in, take two years to live in it and fix it up, then sell as a personal residence and get a reduced taxable gain amount.  The reduced taxable gain amount depends on use between 1/1/2009 and date of sale.

I have seen an owner of several rentals move into one of the homes, fix it up over two years, sell as a personal residence taking the adjusted home sale gain exclusion to reduce taxable gain. They then moved into the next rental, worked on it for two years, sold it as a personal residence taking the adjusted home sale gain exclusion to reduce gains and so on.  You would need to see a tax advisor to work out the adjusted home sale gain exclusion.

The exclusion of gain on a personal residence sale can be used only once every two years but there is no lifetime limit on how many times you can use it.

1031 Exchange of a Rental to Defer Tax on Gains:  You can sell a rental and buy another one and move the gains from the old one to the new one but there are several not so easy conditions to meet.  You sell the old rental and the money sits in an escrow account, held by an Accommodator.

Within 45 days of the sale date, you must present a list of up to three properties (can be raw land also) to the Accommodator and close on at least one of those three properties using the money held in escrow within 180 days of the sale date.  If the buy price of the new property is lower than the sale price of the old property, there is a very good chance you will pay tax on the difference. If it is the same or more as the property that was sold, all the gain rolls into the new property and there is no tax. 

There is such a thing as a reverse 1031 exchange which is a bit more complicated as the property bought will be held by the Accommodator in an entity until the old one is sold. Timing deadlines are the same. You can move into an exchanged property, after it has been a rental for about two years, as a personal residence but you can't sell it for five years from the exchange date or else the exchange will be voided and tax due on the gain.

Notes:

(a.) You should attach a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" to the timely filed original federal tax return including extensions for the taxable year in which the de minimis amounts are paid. The statement should include your name, address, and Taxpayer Identification Number, as well as a statement that you are making the de minimis safe harbor election. Under the election, you must apply the de minimis safe harbor to all expenditures meeting the criteria for the election in the taxable year.

(b.)Sample Election Statement

(Reg. Sec. 1.263(a)-3(h)) Small Taxpayer Safe Harbor Election for Building Property

[Taxpayer Name]

[Taxpayer Address]

[TIN]

The taxpayer is hereby making the safe harbor election for small taxpayers under Reg. Sec. 1.263(a)-3(h). The election applies to the following eligible building property (or properties):

[Description of each eligible building property to which the election applies]

(c.) MAGI- For this purpose is your adjusted gross income figured without the following.

• Taxable social security and tier 1 railroad retirement benefits.
• Deductible contributions to individual retirement accounts (IRAs) and section 501(c)(18) pension plans.
• The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses.
• The exclusion from income of amounts received from an employer’s adoption assistance program.
• Passive activity income or loss included on Form 8582.
• Any rental real estate loss allowed because you materially participated in the rental activity as a Real Estate Professional (as discussed later, under Activities That Aren't Passive Activities).
• Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the Instructions for Form 8582).
• The deduction allowed for the deductible part of self-employment tax.
• The deduction for domestic production activities.
• The deduction allowed for interest on student loans.
• The deduction for qualified tuition and related expenses.