I have clients who love to regale me with stories about their fun experiences with tenants. Like the one who literally took everything that was not bolted down when he moved out: Carpeting, curtain rods, towel bars, you name it. In fact, he even took one thing that was bolted down - a toilet, believe it or not.
Putting up with tenants can be a real pain, but that negative consideration is offset by surging real-estate markets and rental rates in many areas, and favorable tax rules. In fact, favorable tax rules are a big reason why so many fortunes have been made in real estate. This column is the first of three on the most important tax issues that landlords, and potential landlords, need to understand.
What you can write off
You can deduct mortgage interest and real estate taxes on rental properties. However, if you pay mortgage points, you must amortize them over the term of the loan.
You can also write off all the standard operating expenses that go along with owning a rental property: utilities, insurance, repairs and maintenance, yard care, association fees and so forth.
The kicker is that you can also depreciate the cost of residential buildings over 27.5 years, even while they are (you hope) increasing in value. Say your rental property, not including the land, costs $250,000. The annual depreciation deduction is $9,091, which means you can have that much in positive cash flow without owing any income taxes. That’s a nice benefit, especially if you own several properties. Commercial buildings must be depreciated over a much-longer 39-year period, but the depreciation write-offs will still shelter some cash flow from taxes.
Beware of the dreaded passive loss rules
If your rental property throws off a tax loss, and most do at least during the early years, things get complicated. The so-called passive activity loss (PAL) rules will usually apply. In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, like positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have more passive income or you sell the property or properties that produced the losses. Bottom line: The PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, there are several exceptions that can allow you to deduct losses sooner rather than later. I’ll cover those exceptions in a future column.
What if I have income?
Eventually your rental properties should start throwing off positive taxable income instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you now get to use them to offset your passive profits.
Another nice thing: Positive taxable income from rental real estate is not hit with the dreaded self-employment (SE) tax, which applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3%, so it’s a wonderful thing when you don’t have to pay it.
One bad thing: Positive passive income from rental real estate can get socked with the 3.8% Medicare surtax on net investment income, and gains from selling properties can also get hit. However, this tax only hits upper-income folks. Consult your tax adviser for details.
Taxpayer-friendly rules when you sell
When you sell a property you’ve owned for more than one year, the profit (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions) is generally treated as a long-term capital gain. As such, it will be taxed at a federal rate of no more than 20%, or 23.8% if you owe the 3.8% Medicare surtax. However, part of the gain â€” an amount equal to the cumulative depreciation deductions claimed for the property â€” is subject to a 25% maximum federal rate (or 28.8% if you owe the 3.8% Medicare surtax). The rest of your gain will be taxed at a maximum federal rate of no more than 20% (or 23.8%). Don’t forget that you may also owe state income tax on real estate gains (and NYC tax for properties in the Big Apple).
On the other hand, it’s important to remember that property appreciation is not taxed until you actually sell. Good properties can generate the kind of compound tax-deferred growth that investors dream about. You can even pocket part of your appreciation in advance by taking out a second mortgage against your property or refinancing it with a bigger first mortgage. Such cash-out deals are tax-free.
You also have the option of selling appreciated real estate on the installment plan by taking back a note for part of the sale price. Then your taxable gain can be spread over several years. You can charge the buyer interest on the deferred payments, but you generally don’t have to pay interest to the government on your deferred gain.
Remember those suspended passive losses we talked about earlier? You can use them to shelter gains from selling appreciated properties.
Finally, the tax law allows real estate owners to unload appreciated properties while deferring the federal income hit indefinitely. Here we are talking about so-called “like-kind exchanges,” which are also known as “Section 1031 exchanges” (named after the applicable Internal Revenue Code Section). With a like-kind exchange, you swap the property you want to unload for another property (the so-called replacement property). You’re allowed to put off paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange yet another like-kind exchange and continue deferring taxes. While you cannot cash in your real-estate investments by making like-kind exchanges, you can trade holdings in one area for properties in more-promising locations. In fact, the like-kind exchange rules give you tons of flexibility when selecting replacement properties. For example, you could swap several single-family rental houses for an apartment building, a shopping center, raw land, or even a golf course or marina.
The bottom line
As I said at the beginning, the tax rules for landlords are pretty favorable, all things considered. I have a couple more articles in mind for all you landlords and landlord wannabes out there, so please stay tuned.