With savings accounts and certificates of deposit paying little to no interest and people still being pretty skeptical of the stock market, many people are turning to residential rental properties for an extra source of income and/or retirement income. They can be a very worthwhile investment, but the tax implications need to be carefully considered as well. We are going to cover some of the basics that every taxpayer should know.
Residential rental properties are depreciated over 27.5 years, straight-line. Only the building can be depreciated and not the land. We’ve seen more than a few times where a taxpayer had been depreciating the entire value. The depreciable cost basis is the lower of the fair market value at the time of initial rental or the cost basis plus improvements. The land and building breakdown can be determined from the county property tax collector website or a property tax bill, which designates an amount for the building and for improvements. From there you can allocate a percentage of the total value to the building and the land. Another thing to note is that the IRS is clear that depreciation is allowed or allowable. In other words, they require you to take it so when you go to sell the property the basis is adjusted for depreciation whether taken or not. If you decide to sell a rental property at a gain, depreciation must be recaptured at 25% and the rest is usually 15% for a long-term capital gain (rate for most taxpayers). Doing a 1031 exchange or waiting to let someone inherit the property are often better choices, but those are whole different topics.
Most assets purchased for a rental property are depreciated over five years (e.g. appliances and furniture) and Section 179 depreciation is not allowed. Items that extend the life of the property (e.g. a roof) are usually depreciated over the life of the property of 27.5 years. Most expenses related to a rental are tax deductible including: homeowners’ association dues, insurance, property taxes, mortgage interest, travel to and from the rental, repairs, the allocable portion of tax preparation, and legal fees.
Some final considerations are rules for vacation rentals and passive loss limitations. On a vacation rental, expenses are only allowed to the extend of income and a loss can’t be created. Expenses allowed are allocated based the number of fair rental days and the number of personal use days. For most full-time rentals (other than for taxpayers considered “real estate professionals”) it is considered a passive activity and losses are limited to $25,000 to offset ordinary income in the current year. However, when adjusted gross income exceeds $100,000 the loss is reduced $1,000 for every $2,000 over $100,000. The loss is completely disallowed in the current year at adjusted gross income of $150,000. If your filing status is married filing separately, the maximum allowed loss is $12,500, which is phased out between adjusted gross income of $50,000 and $75,000.
As always, thank you for checking out our blog and hopefully the information provided on residential rental properties is helpful in outlining many of basics when it comes to these big, but worthwhile investments!