« Tax Issues For Foreign Students – F Visa & Opt Status | Main | Capital Gain and Loss Tax Issues »
Rental Property Tax Issues
By cpa | April 25, 2008
When you purchase property and rent it out, you’re essentially running a business. You receive rental income and incur expenses from the property. You hope that, your revenue exceeds your expenses so that your real estate investment produces a profit for all the money and time you’ve invested. You also hope that the market value of your investment property appreciates over time.
You could possible having positive cash flow but taxable loss on the return because of depreciation. Depreciation expense is a tax deducible expense, but doesn’t involve your cash outflow. After depreciation, you are possible to show a loss for the year, but you are able to deduct the loss on your tax return. If you actively participate in managing the property, you’re possible to be allowed to deduct your losses against your other taxable income and save taxes.
Deductible Expenses
In addition to the deductions allowed for mortgage interest and property taxes, you can also deduct almost all of the money that you spend on the property. For example, insurance, maintenance, management, advertisement incurred in finding tenants, traveling expenses (mileage) to look after the properties, legal & accounting professional expenses, commissions paid to find tenants, utilities, repairs and capital improvement.
IRS agents pay close attention to repair and maintenance deductions claimed on the very aggressive tax returns. Most taxpayers would prefer to classify the expenditure as a repair and taking a current year deduction, rather than by capitalizing the expense and depreciate the cost over the applicable years.
Here I would like to point out the differences between repairs and capital improvement. The Internal Revenue Service, has defined the difference between repairs and improvements in Pub.527as follows:
“A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life.”
“An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses.”
Capital improvement need to be depreciate over the applicable years. Depreciation is an accounting deduction that the IRS allows you to take for the overall wear and tear on your building. The idea behind this deduction is that, over time, your building will deteriorate and need upgrading, rebuilding, and so on. The IRS tables now say that for residential property, you can depreciate over 27-1/2 years, and for nonresidential property, 39 years. Only the portion of a property’s value that is attributable to the building. Please note that land can not be depreciated.
For example, suppose that you bought a residential rental property for $300,000 and the land is deemed to be worth $100,000. Thus the building is worth $200,000. If you can depreciate your $200,000 building over 27-1/2 years, that works out to a $7,272 annual depreciation deduction.
If you have large mortgage, after depreciation and all other expenses, you are possible to show a taxable loss for the year. If your adjusted gross income is less than $100,000 and you actively participate in managing the property, you’re allowed to deduct your losses on operating rental real estate for up to $25,000 per year.
If you make more than $100,000 per year, you start to lose these write-offs. At an income of $150,000 or more, you can’t deduct rental real estate losses from your other income. People in the real estate business (for example, agents and developers) who work more than 750 hours per year in the industry may not be subject to these rules.
Suppose that you purchase a rental property many years ago and now the property worth much more than you originally paid for it. However, when sell the property, you owe taxes on your gain or profit. For example, if you bought the property for $100,000 and sell it for $150,000, you not only owe tax on that difference, but you also owe tax on an additional amount, depending on the property’s depreciation. The amount of depreciation that you deducted on your tax returns reduces the original $100,000 purchase price, making the taxable difference that much larger. For example, if you deducted $25,000 for depreciation over the years that you owned the property, you owe tax on the difference between the sale price of $150,000 and $75,000 ($100,000 purchase price minus $25,000 depreciation).
All this tax may just motivate you to hold on to your property. But you can avoid paying tax on your profit when you sell a rental property by “exchanging” it for a similar or like-kind property, thereby rolling over your gain. The section of the tax code that allows rollovers is a 1031 exchange. We will talk about it in detail in a separate article.
Another strategy is to utilize IRC 121 gain exclusion. You may convert the rental property to your residence. The basic gain exclusion qualification rule is simple. You must have owned and used the home as your main residence for at least two years out of the five-year period ending on the date of sale. If you are married, the full $500,000 break is available as long one or both of you satisfies the ownership test and you both satisfy the use test.
Say you are married and own three homes. First there’s your current main home, which qualifies for the $500,000 exclusion and could be sold for a $400,000 gain. You sell it tax-free and move into your vacation home in
If you do not mind keeping moving to different homes, you can repeat the gain exclusion every two years.
Topics: Investing in Real Estate |