Cracking The Secrets to Rental Property Tax Deductions 1

A few weeks ago, a friend of mine asked me to compare some of the tax and economic consequences of purchasing a house under various situations. It was a great idea. As I started writing, though, I realized that I should probably touch on the tax consequences of each scenario first before I tried to compare them all.

Especially since one of them had been on my “to discuss” list for nearly a year.

Besides, I just did some research into rental property tax deductions for a family member, so why let all that information go to waste?

Note On Vacation Property

Before you get too invested in this riveting tax information, I should point out that if you want use this rental property as a vacation home part of the year, the rules will change a bit. If you want to read more about that, check out this page.

Vacation

We need a picture of a house here. This is where I live. . .in those weird dreams where I need a place to store my rocket launching speedboat.

Let’s Talk Deductions

If you’ve finally decided to take the plunge and buy a rental property, congratulations, you’re in business now! Even if you’re planning on sticking that property rental on your personal tax return, you have to get your mind out of the personal tax gutter and start thinking the business tax way.

The first thing to remember with business taxes is that you don’t have deductions. There’s no rental property tax deduction, per se. It’s business income and business expense.

What does that mean? If you have a legitimate business expense related to maintaining your rental, you can put it on your tax return as an offset to your rental income.

This will include almost any related expense that you can imagine. Mortgage fees, interest, repairs, advertising, etc. The IRS has a pretty comprehensive list on the 1040 Schedule E (which you’ll have to attach to your return), but notice that there is an “Other” category if your expense isn’t on the list. Just make sure it’s a legitimate business expense, or the IRS will go after you (and, as always, it’s best to check with a CPA or Enrolled Agent to make sure you have an IRS approved definition for the word “legitimate”)

At the end of the day, you’ll take all your rental income, combine it with your rental expenses, and you’ll come up with that magical figure us accountants call “net income.” That net number will flow up to your 1040 and is factored in with your other income and deduction items.

Specific Deductions

Based on a friend’s comment, I wanted to expand a little bit on the deductions allowed. As noted above, some will be fairly obvious operating expenses. Pay for a cleaner? You get a deduction. Toilet backed up and need to call a plumber? You get a deduction.

Things get a little bit trickier with the payments surrounding any mortgage. As mentioned above, mortgage interest is deductible (though probably shouldn’t be). Property tax would also be a legitimate business expense. Paying back the loan itself, however, wouldn’t be a deduction. That’s just a matter of giving back money from a loan. Just like if a friend lets you borrow $20 to impulse buy a garish sequin polo shirt, it’s a nontaxable transaction when you finally give the $20 back.

It’s not all bad news, though. You can take depreciation on the rental, which means you get a deduction unrelated to cash outlays. I don’t want to get into it too much here, but basically you can take the value of the property and expense that value a little bit every month over 27.5 years.

For more information property depreciation, see IRS Pub 527. Just keep in mind that the depreciation you take on your property lowers its basis, which potentially leads to a bigger gain when you go to sell the property years later.

Wait, What If I Have A Net Loss?

Business can sometimes go wrong. Maybe you couldn’t find Mr. and/or Ms. Right to occupy your rental property. Maybe the hot water heater burst through the roof. Maybe that orange and green shag carpet just had to go. Whatever the reason, it’s possible that in some years your rental expenses will be greater than your rental income. What then?

Well, things can get a bit tricky. Our blessed government doesn’t want people investing in businesses just to lose money and lower a tax bills. They are particularly concerned with passive investments, in which they’ve lumped in all rentals. If you have a loss, they don’t want you offsetting your hard earned income with that rental loss.

It sucks. They are okay if you carry that loss forward and offset future rental income, but in the year that the loss happens, the general rule says you’re screwed.

However, there is some relief. If you (and/or your spouse) own the rental property personally, and you “Actively Participate” in the running of the rental property, the IRS will allow you to take up to $25,000 net loss against your ordinary income each year.

That’s really not too bad. For most people who own only a rental property or two, that $25,000 is more than enough to cover any losses you may have.

Get beyond $25,000, though, and you will have to carry over the excess loss.

Actively Participate

“Wait,” I’m sure some people are thinking, “that ‘Actively Participate’ that you put in quotes sounds like something official.”

Great thought, Reader! Active participation is an official tax phrase with an official IRS definition and everything. It means that you don’t have to do everything, but you do have to make management decisions (“in a significant and bona fide sense”). The kind of decisions the IRS is looking for includes approving new tenants, setting rental terms, approving expenses, picking the replacement color for that terrible shag carpet, etc.

Basically you can’t just buy a property and hand it over to a management company to run. If you do, you won’t be able to take that $25,000 loss.

Liability Concerns

If you own a rental property, there’s a chance you could have liability issues (i.e. get sued). While this isn’t strictly a tax issue, one item you could do to help with some of that liability is to contribute the property into a Single Member Limited Liability Company. An SMLLC, as they are called, will give you some protection against lawsuits, but for tax purposes will still be considered owned by you personally (so you can get that $25,000 loss deduction).

If you do go that route, you’d have no extra tax paperwork. Just fill out the information on the Schedule E just as you would have done before.

Of course I am neither a lawyer or a Real Estate Agent, so you’d want to check with those guys to see if this raises any sort of legal red flag.

Could I Put The Rental Property In An S Corp?

If you’re an amateur tax planner, you might have heard that S Corps can help you with tax planning. Can they help you with your rental property tax deduction, too?

The answer is that they possibly could, but don’t do it. Not unless you really know what you’re doing. Any sort of losses would have to go through the “Material Participation” test, which is more strenuous than the Active Participation I mentioned above. Beyond that, as one of my Twitter Associates (a.k.a. a total stranger) pointed out, sticking Real Estate in a corp is just a bad idea.

Any Tax Avoidance Ideas?

Let me start out this section by saying that buying anything with the sole hope of lowering your tax bill is probably a bad idea. However, structuring your purchase to have as low a tax bill as possible is not only good, it’s Supreme Court Approved.

In terms of running the rental property, all the standard rules apply (track all your business expenses like a Comic Book Fanatic tracks their collection). Make sure that the business expenses are really for the business, and that your personal expenses do not end up in that business expense pile.

Beyond that, I do have one tip that might work for you.

If you live in a home for 2 out of 5 years, you don’t have to recognize a gain on it when you sell it. If you’re looking to sell your rental property, there’s nothing tax related saying you can’t move into that house for the two years before you sell it. Then, you can exclude up to $500k of gain.

Will that work for everyone? No, of course not. But while you’re planning ahead, it can’t hurt to see if you can make that work. Maybe buy that house down the street instead of the one in the city next door. It just might save you a few bucks years from now.

  • Jason Hirst

    As your token lawyer, I will respond to the legal issue you raised about putting the rental property inside a company…

    Asyou pointed out, the primary reason for setting up a company to hold
    title to a rental property is for liability protection. That is, if your
    name is on the title to the property, anyone injured on the property
    can sue you personally. If title is held by a company, they are probably
    stuck with suing the company instead of you. Also, you can use your
    company to sign any contracts, purchase equipment, etc., so that any
    liability that arises from those contracts or assets would also be
    limited to the company, as well as any contractual claims. If you don’t
    pay your gardener, and the contract is with the company, the gardener is
    going to have to collect from your company. Though the gardener might
    still show up at your house with a hedge trimmer, but there’s nothing I
    can do about that.

    I wouldn’t want to over-hype the risk of owning a house, but lawsuits against property owners happen all the time. I would guess this is mostly because everyone assumes that the owner of a rental property has deep pockets. If you only own one rental property, you might be on the fence about whether this is necessary. If you own more than one, it’s most likely a good idea.

    If you are forming an LLC (the entity of choice for a lawyer) you will most likely
    get both inside-out and outside-in protection (meaning that lawsuits
    against the company won’t bleed over to your personal assets, and
    lawsuits against you personally won’t be able to attach the company’s
    assets, at least not very easily). How strong that protection will be is
    determined by things like how you keep separate financial records,
    maintain separate bank accounts, whether or not you are the sole owner
    (SMLLCs in some states may offer very little real protection), how well
    you remember to use your company’s name instead of your own, and how
    well you keep records, minutes or other requirements set by your state.

    Also you should be aware that there are costs to forming and maintaining an
    LLC, though often they aren’t substantial. You have to jump through the
    hoops of formation, pay a filing fee (and sometimes a renewal fee every
    year – which in CA is something like $800), and you may be exposed to
    some additional taxes from the state (Texas has a franchise tax, though
    this doesn’t typically kick in unless you are doing over a million in
    gross revenue). You also have some of the additional time and expenses
    to comply with the requirements stated above.

    LLCs offer the best asset protection and generally have fewer bookkeeping requirements than corporations, so they are the entity of choice. Even though accountants seem to hate corporations (taxes as a C-corp anyway), it is usually the accountant who would recommend a corporation for some funny tax
    business (benefits for saving for retirement, paying for healthcare,
    etc.).