I’m often asked if buying a rental property is a good idea. When it comes to real estate, I am the first to admit that I have never had much luck, and you should always consult with a realtor as to the sound financial sense of making an investment. But, what I can offer is a clear answer on the tax benefits of such an investment, as they are far more confusing than people anticipate.
On the surface, rental property deductions are pretty straight-forward. If you look at Schedule E of a tax return, you’ll see a fairly simple form that asks for the gross income from the rental property, and then subtracts out the expenses that it costs to run that property, such as mortgage interest, real estate taxes, insurance, accounting fees, association dues, repairs and supplies.
Towards the bottom of the form, there is a line for depreciation, and that’s the trickiest of the deductions. Residential rental properties are depreciated over 27.5 years and commercial properties are depreciated over 39 years. What’s depreciation? That means that you take the total cost of the property, less the amount that the land is worth, and you divide that cost by the number of years. If a condo cost $275,000, then the annual depreciation would be $10,000.
Depreciation can certainly be a very substantial deduction, but there are two important factors to consider in depreciation. First, some taxpayers and even some accountants, fail to claim depreciation on a rental property. Whether in error or as part of a tax strategy, the IRS is clear that depreciation is not option and must be claimed each and every year. The second factor is called depreciation recapture. When you sell a property, you must pay tax on all the depreciation you deducted in the past, generally at a rate of 25 percent. The IRS requires you to pay tax on depreciation even if you didn’t take the deductions along the way, based on the law that depreciation is not optional. This can be a major surprise to investors when they sell the property, so it’s important to give it consideration along the way.
The other big surprise to many real estate investors are the passive-loss rules. While the full context of the rules would take a book to describe, the basic point is this: rental property losses are not necessarily deductible in the year they are incurred. If you actively participate in a property, most often meaning that you don’t have a property manager involved, then you can deduct up to $25,000 in losses from a property as long as your adjusted gross income is less than $100,000. After that, those losses are limited. If you hire a property management firm, you are less likely to be considered actively participating, and you cannot take deductions that cause a loss on your tax return, and that loss must be carried forward until the sale of the property.
If you find a sound real estate investment, I’m not suggesting that the tax benefits would make it not worth the investment. I’m only stating the opposite. If you think a rental property is a good tax strategy, be sure that you fully understand the concepts of depreciation and passive loss rules because you make the investment. For many taxpayers, rental properties work great, but that is not always the case.
Michele Knight, owner of Knight Accounting & Technology, is a CPA and QuickBooks ProAdvisor based in Dillon. For more info and to contact her, visit www.cpamichele.com.