The IRS taxes investment property under two main tax regimes: Income tax, which generally applies to cash or other goods and services you receive in lieu of cash from tenants, and capital gains. Capital gains tax applies to the profitable sale of investment property. State and local governments also impose taxes that vary by jurisdiction. This article focuses on the federal tax picture.
What is Taxed on a Rental Property?
Rental Income. You are required to report all rent payments by the tenant, even if it is paid in advance, during the tax year in which you received it. If your tenant gives you two years worth of rent in one payment, you must claim not only the current tax year’s rent as income, but the entire lump sum of money received as rent.
Security Deposits. If you take a security deposit from a tenant, you must hold it in a separate account by the owner/manager of the property for the lifetime of the rental
agreement. Upon termination of the agreement, any money held back from the security deposit is taxable as income during the tax year in which the agreement was terminated. For example, if you accepted a $1000 security deposit, but only returned $800 because you needed to repair the drywall your tenant damaged, you must report the $200 as income.
Capital Gains. Capital gains tax is the tax upon the net profit of your rental property after you sell it. Net profit is calculated by deducting the original sales price of the home as well as any capital improvements from the new sales price. If you have owned the home for less than 12 months (think “flipping real estate”), you will pay short-term capital gains taxes which is the same as your marginal tax rate. Long-term capital gains taxes are much lower – maxing out at 15 percent as of 2012. Those rates will go up to 20 percent in 2013, though, unless Congress sooner intervenes.
Expenses Paid by Tenants. Let’s say you’re going out of town and have told your tenant that should there be a need for an emergency repairman, they can call one and deduct the cost from the rent. Turns out that a pipe broke, and a plumber needed to be called immediately. It cost $400 to repair that pipe, so your tenant submitted the repairman’s receipt for $400 and a check to you for the other $400 of rent. You must declare the full $800 worth of rent for that month as income, though you may be able to deduct the cost of repairs. If the project is a capital improvement, though, see below for rules concerning those items.
Work Done by Tenants. If you agree to receive services from the tenant at the value of $800 instead of $800 cash for rent, you must declare that $800 of work received from the tenant as income. However, depending on what type of work was done, you may be able to deduct the work as a business expense, or amortize the cost over the useful life of the property repaired.
Reducing Taxes on Investment PropertyDepreciation.
Depreciation is the process of spreading your deductions for the cost of improving the property over the expected useful life of the property. You can’t deduct the entire cost of the house in the year you purchased it as a business expense; Instead, you divide the cost of the house by 27.5 years (under 2011 MACRS rules), and deduct that from your rental income. For example, you purchase a home for $275,000. For the next 27.5 years, you can take $10,000 worth of depreciation against your tax burden. The same can be said of other capital expenses, such as improvement to the home including replacement of appliances.
Make yourself familiar with what can be depreciated and over how long an item’s lifetime is defined.
Business Expenses. Just like any other entrepreneur, you run a business and are entitled to deduct business expenses. Office space, advertising, and travel are just a few of the many deductions you may take. Others include can include
o phone charges
o mileage at 58 cents per mile you drive for business purposes
o contracting services related to business (lawyers, property management companies, etc.)
o mortgage interest
o local property taxes
If you run a home office, make sure you separate and get an accurate reflection of the percentage of personal use versus professional expense
Note: Business expenses are generally subject to passive activity rules. You cannot generally deduct more in business expenses than you have in gross profit from the property. Certain exceptions apply for small landlords, however.
Insurance. You may deduct the insurance premiums for a rental property, but not for a residential property. You may also deduct losses on the property should there be a loss.However, if you make a claim against that insurance and receive payment, you need to balance the deductable, total valuation of the loss and amount received from the insurance company against each other to ensure the correct deduction.
1031 Exchanges. A 1031 exchange, also known as a “like-kind exchange,” allows you to roll over the capital gains of a previous rental property sale into the purchase of a new rental property sale. By doing this, you are able to postpone and/or avoid in the long term the capital gains taxes you might have paid on the initial property sold. These exchanges can only be used on rental properties, not personal property.
Capital Losses. If you sell property at a loss, you can deduct any losses against your capital gains elsewhere in your portfolio, and cancel taxable gains out, dollar for dollar. If you still have losses left over, you can deduct them against up to $3,000 in income on personally-owned investment property. If you still have losses left over, you can carry the losses forward and deduct up to $3,000 per year each year until you run out of losses.
Personal use of Rental Property. This is where accounting can get sticky. If you have used your rental property as a primary residence or a vacation home, you must prorate your deductions against the amount of time you were personally using the property against the amount of time you were renting out the property. For example, if you used your rental as a personal vacation home for six months and rented out the property for the other six months, you may only deduct 50% (6 months divided by 12 months) of deductions
Note: If you are holding your rental property within an IRA or other tax-advantaged retirement account, you cannot use your property for personal use at all. You can’t even stay in it while you are personally working on the property. The same holds true for your spouse, your ascendants and descendants and their spouses, and any advisors working with you on the account. If you use the property for your own uses, or if any of these prohibited individuals do so, the IRS may revoke the account sources status, resulting in taxes and possible penalties.
Make yourself familiar with the IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), with each new tax season. Tax laws change constantly; consult with a Certified Public Accountant or a tax lawyer to ensure you are in compliance with all laws as well as to take advantage of all deductions. Keep all receipts and keep meticulous records of all income and expenses; you don’t want to be on the wrong side of an IRS audit.