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Taking a Page Out of History and Collecting a Valuable Tax Break

Have you always wanted to buy rental property and become a landlord? As you can imagine, putting up with some tenants can be a pain in the neck. But the discomfort can be eased by the valuable tax breaks available to rental property owners. In fact, favorable tax laws are one big reason why so many fortunes have been made in real estate. Another big reason is that leveraging real estate investments with mortgages can multiply profits.

But for purposes of this article, let’s stick to taxes. Here are some important things landlords should know:

What Can You Write Off?

Of course, 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 (unlike points on a mortgage to purchase a principal residence, which can be deducted immediately).

In addition, you can write off all the other operating expenses — such as utilities, insurance, homeowner association fees, repairs, maintenance and yard care.

One of the best tax breaks is the fact that you can depreciate the cost of residential buildings over 27.5 years, even while they are (hopefully) increasing in value. Let’s say you purchased a rental property (not including the land) for $100,000. The annual depreciation deduction is $3,636, which means you can have that much in positive cash flow without owing any income taxes. That’s pretty valuable, especially if you own several properties. Commercial buildings must be depreciated over a much longer time (39 years), but the write-offs still shelter some cash flow from taxes.

Beware of the Passive Loss Rules

Rental property ownership gets complicated if your property throws off a tax loss — and most do at least during the early years. The so-called passive activity loss (PAL) rules will probably apply. The fundamental concept: You can only deduct passive losses to the extent of passive income from other sources — such as positive operating income from other rental properties or gains from selling them.

Fortunately a special exception says you can generally deduct up to $25,000 in passive losses from rental real estate so long as:

  1. Your adjusted gross income (AGI) before the real estate losses is under $100,000.
  1. You “actively participate” in the rental activity. Active participation means owning a 10% or greater stake in the property and being energetic enough to at least make management decisions like approving tenants, signing leases, and authorizing repairs. In other words, you don’t have to mow the lawn and snake out the drains yourself to pass the test. But if you use a management company to handle all the details, you can forget about taking advantage of the $25,000 exception.

If your AGI is between $100,000 and $150,000, the exception is phased out pro-rata. So an AGI of $125,000 means you can deduct up to $12,500 in passive real estate losses (half of the $25,000 maximum) even if you have zero passive income.

Bottom line: Rental property owners have to watch their AGIs carefully. Every $2 over the $100,000 threshold costs a dollar in current passive loss deductions. For example, say your AGI is shaping up to be right around the $100,000 borderline. You might want to consider planning moves that will reduce your AGI this year, or at least not cause it to go up. Selling some loser stocks or mutual funds could be a really good idea, while selling some winners may only make Uncle Sam happy.

If your AGI is above $150,000 and you have no passive income, you generally cannot currently deduct a rental real estate loss. However, your loss carries over to future tax years. You will eventually be able deduct your carryover losses when you either sell the property or generate some passive income. All in all, this is not a bad outcome as long as you just have “paper losses” caused by your depreciation write-offs.

What If You Have Income?

Eventually, your rental properties should start throwing off positive taxable income instead of losses because rents surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up some carryover passive losses in earlier years, you now get to use them to offset your profits. So you may not actually owe any extra taxes for a while.

Another benefit: Positive taxable income from rental real estate is not hit with self-employment (SE) tax, which applies to most other profit-making ventures other than working as an employee and investing. Depending on your situation, the SE tax can be either 15.3% or 2.9%. In either case, it’s beneficial when you don’t have to pay it.

As you can see, the tax rules for rental real estate are pretty favorable.

Important Exceptions to the PAL Rules

First: If your property is in a resort area, the average rental period may be seven days or less. In this case, the IRS considers you to be running a business rather than a rental operation. Now, if you “materially participate” in running this “business,” you’re exempt from the PAL rules and can deduct your losses currently.

So what does it take to materially participate? In a nutshell, you must either spend:

  • More than 500 hours annually taking care of the property or
  • More than 100 hours with no one else spending more time than you do.

Remember, this material participation exception applies only if the average rental period is seven days or less. If you use a management company, you will probably fail to meet the participation guidelines.

Second: There’s yet another PAL exception that applies only to people who have become heavily involved in real estate. To take advantage, you must spend more than 750 hours annually in real estate activities that in which you materially participate. And those hours must involve more than 50% of the time you spend working for a living. There are some other hurdles, but if you clear them, you’ll be exempt from the PAL rules and therefore be able to currently deduct your rental losses.

Please contact Tom Burton via our online contact form for more information.

Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.