Investing in a residential rental property raises various tax issues that can be confusing, especially if you are not a real estate professional. Below are some more critical matters rental property investors should know about.
Rental Losses
Owners of residential rental properties may depreciate their buildings over 27.5 years. For instance, a property acquired for $200,000 could yield a depreciation deduction of as much as $7,273 annually. Additional depreciation deductions can be available for the furnishings provided within the rental property. When a significant depreciation deduction is added to other rental expenses, the rental activity often generates a tax loss. The next question, then, is whether that loss can be deductible.
$25,000 Loss Limitation
Tax laws generally treat real estate rental losses as “passive.” It is, therefore, available only to offset any passive income a taxpayer may have. Regardless, a limited exception is available where an owner holds at least 10% ownership interest in the property and “actively participates” in its rental activity. In such a situation, passive rental losses up to $25,000 may offset nonpassive income, like a wage from a job—the $25,000 loss allowance will phase out with the modified adjusted gross income between $100,000 and $150,000. Passive activity losses not currently deductible will be carried into future tax years.
What is active participation? The IRS defines it as making management decisions or placing others to provide services in a considerable and bona fide sense. The IRS gives examples of such management decisions, like deciding rental terms and approving tenants.
Selling the Property
A gain acknowledged on the sale of a residential rental property held for investment is typically taxed as a capital gain. If the gain is long-term, it is taxed at an advantageous capital gains rate. Yet, the IRS mandates that any admissible depreciation be “recaptured” and can be taxed at a 25% maximum rate instead of the 15% or 20% long-term capital gains rate that commonly applies.
Exclusion of Gain
Tax laws have a generous exclusion for gain from selling a principal residence. Generally, taxpayers can exclude up to $250,000 ($500,000 for some joint filers) of their gain if they own and use the property as their principal residence for two out of five years before the sale.
After the exclusion was legislated, some landlords moved into their properties and designated them as principal residences to benefit from the home sale exclusion. As such, Congress subsequently changed the laws for sales completed after 2008. Under the current regulations, the gain will be taxable to the point the property wasn’t used as the taxpayer’s principal residence following 2008.
This rule can trap the unwary. For instance, a couple might buy a vacation home and rent the property to finance the purchase. Later, upon retirement, the couple can turn the vacation home into their principal residence. If the house is subsequently sold, a part or all of the gain on the sale could be taxable, as mandated by the rule described above.
