After appreciation, the number one benefit of owning rental real estate is the ability to claim the tax deductions allowed to owners of rental property that can offset their other income and reduce the total tax owed. Owning rental property is one of the most accessible legal tax shelters available to the general population. IRS Publication 527 Residential Rental Property (Including Rental of Vacation Homes) has a summary of all of the deductions allowed to owners of rental property. Click HERE for a copy.
Many expenses paid by the owner will be deductible and it is important to keep receipts and other documentation related to these expenses. Following are some of the most common expenses allowed to owners of rental properties:
- Cleaning and Maintenance
- Commissions paid to Realtors
- HOA Dues
- Insurance Premiums
- Legal Fees
- Mortgage Interest
Fees charged by an accountant or Certified Public Accountant (CPA) to assist with the record keeping and preparation of tax returns may also be deductible in whole or in part as rental expenses. The list above is not meant to imply that the expenses listed above are the only expenses that are deductible. These are the most common but depending upon the circumstances, other expenses may be deductible.
Additional areas that may generate tax deductions but which require proper analysis and application of the tax rules include:
- Transportation and Travel expenses (to and from the rental or related to the rental);
- Improvements to the property;
- Depreciation of property and improvements
Depreciation often ends up being the largest tax deduction and it generates the greatest tax savings. In reviewing tax returns in connection with the mortgage application process, I often note that the calculation for depreciation is incorrect or in some cases the owners have not claimed depreciation at all.
Annual Income and Loss
In calculating the net income or loss from Rental Property all of the allowable deductions are subtracted from the Rental Income collected. The resulting amount will either be income or a loss. To the extent it is income the amount will be taxable at the owners’ marginal tax rate. Additionally, beginning in 2013 in certain limited circumstances this income will also be subject to a surtax enacted as part of the “Affordable Health Care Law”. The surtax is beyond the scope of this discussion but should not be ignored.
In cases where the activity for the year results in a loss, such amounts will generally be deductible and reduce the owners’ income and overall tax liability. It is important to note that there may be limitations on the amount that is deductible on the tax return due to the Passive Activity loss rules and the At-Risk rules. Again a discussion of these rules is beyond the scope of this discussion however, it is highly recommended that qualified tax professionals be consulted to ensure these rules are applied correctly.
SALE OF PROPERTY
It is important to remember that when a rental property is sold it is necessary to determine if there is taxable gain or loss on the property. This calculation can be complicated and requires that records regarding the purchase, all improvements and all depreciation claimed be maintained for each year the property is owned. Any gain on the sale of Rental Property is subject to federal and state income tax, unlike the gain from the sale of a primary residence which for most taxpayers can be excluded from income if they qualify. On the other hand, if a loss is incurred upon the sale of property the loss will generally be deductible, although it may be subject to various limitations on the amount that is deductible.
Additionally, when a property is sold it is necessary to calculate whether any of the gain or loss is attributable to depreciation that was claimed in prior years. This calculation is necessary in order to determine how much of the gain, if any, will qualify for capital gain treatment versus how much will be treated as ordinary income. Generally, Capital Gains are taxed at lower rates than ordinary income.
In summary, owning rental properties can provide significant tax benefits on an annual basis and can reduce the owners overall tax bill by thousands of dollars a year. However, in order to take full advantage of the tax benefits available and, just as important, to ensure that all of the various tax rules are applied property, I strongly suggest that anyone that owns rental property retain a qualified CPA to assist with the taxes. The cost of not taking full advantage of the tax law and the penalties for not fully complying with all of the requirements make the additional cost of hiring a CPA a no-brainer.
If you do choose to hire a CPA it is important that they understand the property and the type of activities the owner is engaged in. This is usually accomplished by the CPA asking various questions and providing the owner a detailed summary of the type of information the owner should be collecting and retaining.
If anyone needs a recommendation for a qualified CPA I know several and would be happy to provide a referral.