The real estate market is cooling off as interest rates climb higher. Many real estate owners are holding their properties to give the market time to recover. Others may want to purchase investment properties for short-term or long-term lease, rent their vacation homes, or build an accessory dwelling units (ADU) on their property. Whether you are holding, buying, or improving, we can provide valuable guidance from a tax planning perspective.
Here are some key tax planning considerations pertaining to rental real estate and other investment properties:
Rental income is subject to Federal and state income tax requirements. Thankfully, expenses attributed to the rental property are deductible. Some common deductions are: mortgage interest expense, property taxes, commissions, repairs and maintenance, depreciation of the building, and improvements. These expenses reduce the taxable rental income and often generate an overall taxable loss.
Not all costs are immediately deductible. Improvements, such as a kitchen remodeling or adding a deck or pool, are categorized as “capital improvements,” and should be depreciated or deducted over a given number of years based on IRS rules. This type of expense taken over several years is called a “depreciation expense.” The building and any improvements on the investment property are subject to depreciation. Land is not a depreciable asset.
Please note that there could also be state tax related issues if your rental property is located in a different state than the one in which you reside. If your rental property is located outside of your home state, you may need to report rental income and expenses in the state where the rental property is located. Many states, including California, will offer a credit for income taxes paid to other states to avoid double taxation on the resident state income tax return.
Many rental property owners put their rental real estate properties into a Limited Liability Company (LLC) often for liability protection or privacy reasons. If a property is owned solely by one person or a married couple, it is generally considered a “disregarded entity.” If your LLC is a “disregarded entity,” there is no further reporting required for Federal purposes. However, some states, including California, may require additional reporting.
You can use the investment rental property personally, but you will want to monitor your personal use carefully to preserve the integrity of the investment property in the eyes of the IRS, paying particular attention to deductibility of rental expenses. If there is personal use on the investment property, certain “indirect” expenses (like mortgage interest and property tax) will need to be allocated according to personal and rental use.
The IRS considers an investment property a “vacation home” for personal use if you use it greater than 14 days in a given tax year, or at least 10% of the rental days during the year at fair rental price. If a property meets the requirements to be considered a vacation home, rental expenses after the indirect allocation to personal use will only be allowed to offset rental income. Any excess is carried forward to future tax years.
If you have the opportunity to rent out any of your personal use properties for 14 days or less annually it could be a great way to generate extra cash-flow, income tax free. The tax code allows you to rent each individual personal use property for two weeks (14 days) or less annually and you get to keep all of the rental income tax-free no matter how much you charge.
Passive Loss Limitations
In general, rental income and expenses are considered “passive.” Rental losses (where rental expenses exceed rental income) are subject to passive loss limitations. This means rental losses will only offset other passive income, such as rental income, and cannot offset income such as wages, interest, dividends, and self-employment income. Any excess passive losses will carry forward indefinitely. These losses may be used in the future to offset passive income and/or be utilized upon the disposition of the rental property.
In limited circumstances, some owners may qualify for an exception from the passive loss rules if they qualify as a “real estate professional”. In order to qualify as a “real estate professional”, certain requirements must be met including:
- More than 50% of the personal services performed in all trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
The election is complex and often reviewed closely by the IRS, so be sure to discuss this with your tax advisor to determine if you meet all the tests to qualify as a real estate professional.
Another possible avenue around the passive loss limitation is if you engage in “short term rentals.” A “short term rental” is one in which the average period of customer use is seven days or less or thirty days or less with significant personal services included. Another important qualification to escape the passive loss limitations for short term rentals is that the taxpayer must materially participate in the rental activity or must be personally involved in the business activity. There are a variety of IRS tests to determine material participation; one test is that you must spend more than 500 hours per year managing the short-term rental business.
As you can see, tax rules related to owning rental real estate are quite complex. If you have or are considering purchasing rental real estate and have unanswered questions, perhaps regarding depreciation rules or how rental income and losses can be non-passive, we recommend scheduling a time to connect with a Realize team member to deepen our understanding of your particular circumstances to see what actions you could take to maximize the possible benefits from your rental activities and minimize your overall income tax liability. Contact us today to schedule a consultation.
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