Rental Property

Owning and managing rental property can be a good thing from an income tax perspective. Generally, the IRS considers this a passive activity that generates passiveincome (or loss). The advantage of it being passive is that any profits are subjected only to income taxes, and not to any social security or medicare taxes (commonly known as the self-employment taxes).  The IRS allows most taxpayers to write off rental losses of up to $25,000 per year and use this to reduce their taxable income. There is an income limitation, and you begin to loose this deduction if your adjusted gross income exceeds $125,000, married filing jointly, (unless you are a real estate professional), and you cannot take these losses at all if your adjusted gross income exceeds $150,000.

Now let’s go through the lines on the Schedule E form where rental activity is reported.

First you must identify the specific property and answer the personal use tests. Let’s say for example that you have a vacation home that you rent out sometimes. Or you own a home and you let a relative live there for free or for a greatly reduced rate. If you (or your relative) use it for personal purposes more than 10% of the time that it is rented or more than 14 days in the year, your situation just got a lot more complicated and is beyond the scope of this information. Please contact us if this is your situation and we’ll address it with you. But for now let’s assume that this is not the case and what we are talking about is regular rental property.

Income: Report all rental income received during the calendar year for each property. Don’t report it if you didn’t receive it. I’m often asked, “Can I write of the $500 of rent that my tenant did not pay me?”. In essence, you do ”write it off” by only reporting what you actually receive.

Advertising: cost of ads in the local papers, signs purchased and displayed, Internet advertising, etc.

Auto and Travel: generally all of the miles driven to manage, maintain, repair, place ads, collect rent, etc., can be deducted at the current IRS mileage rate. You need to keep an accurate mileage log or record of all of the miles driven for rental purposes.

Cleaning and Maintenance: costs of cleaning supplies, mops, buckets, chemicals, lawn service, etc. Also include what you paid for labor to someone else if you paid to have it cleaned and maintained.

Commissions: include referral fees paid to someone else, such as a real estate professional, to send you tenants.

Insurance: Include all premiums paid to insure the property. Remember that sometimes the insurance is paid from an escrow account by your mortgage holder – you still paid it, so you’ll need to know the amount.

Legal and Professional fees: Lawyers, accountants, court costs, etc. But you can also include income tax preparation fees that you paid specifically for the preparation of the rental property related forms. If you don’t get a detailed breakdown of the charges from your tax preparer, ask for it so that you can identify the charges specific to the rental property.

Management Fees: If you hire a management company to handle the property for you, include their charges here.

Mortgage interest paid to banks, etc: Include only the interest that you pay on loans for which you can identify, or trace, the use of the money to the rental property. For example, if you obtained a second mortgage on your personal home and used the proceeds to acquire rental property, you will deduct the interest on that loan here. This can get quite complicated if you split the use of the proceeds. For example, let’s say you obtained a second mortgage loan and used part of the proceeds for the rental property and part of the proceeds to put a swimming pool in your back yard. This is OK, but you must now pro-rate the interest paid and deduct only the part that you can trace directly to the rental property here on Schedule E. The interest on the personal part of the loan can be deducted on schedule A.

Other Interest: paid for specific loans, credit cards, etc, used specifically for the rental property.

Repairs: This one is tricky. Include here only the cost to fix something that is broken. The repair will be necessary to keep the property in good order, but the repair will not increase the property’s value or life expectancy. Examples: broken window, leaky toilet, repairs for the air conditioning unit or furnace, clogged plumbing, etc. See the discussion on depreciation later for items that add value or increase the life expectancy of the property.

Supplies: Paint, rollers and brushes, furnace filters, light bulbs, etc.

Taxes: Real estate taxes, personal property taxes if applicable, etc. Keep in mind that if you bought or sold rental property the taxes may have been pro-rated and paid at the closing, so you will need the closing statement(s). Also, if the real estate taxes were paid from an escrow account by your mortgage holder, you still paid them so you will need this amount.

Utilities: electric, gas, water, that you actually paid.

Other: Anything else that you paid for that was necessary to operate the property but did not fit into any of the categories above. Examples: garbage service, termite service, tree removal, etc.

Depreciation: Different types of assets have different classes of what the IRS calls “class life”. When you acquire a rental property, it will contain several different types of assets. For example, you will have the land it sits on, the dwelling itself, appliances, and land-hold improvements. Land is not depreciable at all. Residential dwellings depreciate over 27.5 years, commercial buildings depreciate over 39 years, appliances, carpeting and fruniture depreciate over 5 years, and land-hold items (anything that is on or below the dirt, such as sidewalks, driveways, water lines, sewer lines, landscaping, shrubbery, trees, etc.) depreciate over 15 years.

You have to establish your total cost basis, which is IRS jargon for the total amount of money you have invested in order to acquire the property. For a simple acquisition, this will usually be the contract purchase price plus certain closing costs paid. Then you add any new capital improvements, such as new roofs, central heat and air units, windows, siding, etc – anything that has a life expectancy of more than one year and adds value to the property.

I know – you paid a total price for the property and don’t have any idea of the cost of these individual items. Here’s a couple of tips. First, consult your property tax assessment. It will usually include an amount for the land, and a separate amount for “improvements”. These things usually do not exactly match what you paid for the property, but they can give you an idea or a ratio of the assessed value of the land and the dwelling that you could use as a guideline. Also, you can consult a real estate appraiser or a real estate professional for some advice or suggestions using their professional experience and opinion as to the value of the individual items. If all else fails, you have to decide how to allocate the costs of the respective items for depreciation. And yes, you have to do it in the year you place the property in rental service. Depreciation is use it or loose it for each year. You can’t wait and catch up later.

What if you inherited the property and didn’t pay anything for it? Then your beginning cost basis for depreciation purposes is fair market value of the house and land on the date of the donor’s death.  For example, let’s say your parents left you their house upon their death. You have an appraisal performed and the fair market value on the date you inherited the property is $100,000. You would then allocate this $100,000 between the various components described above. Inheriting property is the very best way to acquire it for tax purposes, because as described, the cost basis accelerates to fair market value on the date of death. If you decide to sell the property right away, and you sell if for fair market value, you will NOT have any tax bill at all. Of course you have to report the sale, but you will be able to zero out any capital gain.

Now let’s discuss another fairly common scenario. Your parents wanted you to have their property, so they ”deeded it over” to you years ago. They continued to live there until they died, but the property was in your name. This is actually a gift of the property to you (assuming that you did not pay them anything for the property). Now you must use your parent’s adjusted cost basis in the property.  For example, let’s say that they bought the property in 1960 for $20,000. While they owned the property they made capital improvements to the property by replacing roofs, windows, siding, landscaping, fencing, driveways, etc, for a total of $30,000. Their adjusted cost basis of the property is $50,000 ($20,000 original price plus $30,000 capital improvements). Since they gave you the property, they also gave you their adjusted cost basis of $50,000. You begin your depreciation by allocating this $50,000 among the various class life assets as described above. It does not matter that the fair market value at the time of their death was $100,000. You have to use your parents adjusted cost basis because the property was given to you. Also, in this situation, if you decide to sell the property for $100,000, you will have a capital gain of $50,000 to pay taxes on. See why inheriting is better from an income tax perspective?