Tax Breaks for Landlords
Like many Americans, you may be thinking of investing in a home or condo that has the potential to appreciate over time while generating a steady stream of rental income. Property investment can be risky given the fluctuations in the real estate market, but the federal government has made buying residential properties for rental purposes more attractive by providing landlords with tax breaks not available to owners of personal residences. If you are considering investing in a rental property, the potential for saving money on your tax bill should figure into your cost-benefit analysis.
Provided the house or apartment is offered for rent at fair market value for most of the year, the property owner is entitled to claim expenses associated with operating and maintaining the residence. As a landlord, you are permitted to deduct mortgage and other interest paid for the rental property, as well as insurance costs, real estate taxes, utilities, and homeowners’ association fees.
Rental property owners are also entitled to deduct the cost of basic home repairs. Generally, the IRS defines a repair as an action taken to keep the property in good operating condition, such as repainting the interior or exterior walls, replacing a window pane, or fixing a leaky pipe. Major improvements undertaken to add to the property’s value, extend its useful life, or adapt the property to new uses are not immediately tax deductible, but they may be depreciated. Examples of improvements include adding a room or deck, putting in storm windows and doors, laying carpeting, and upgrading wiring.
Landlords are permitted to recover the cost of improvements over their useful lives as defined by the IRS. The building itself may be depreciated over a period of 27.5 years. While this may seem like a long time, it is much shorter than the 39-year depreciation period that applies to commercial properties. The depreciation deduction is particularly advantageous considering that residential properties tend to appreciate in value over time.
As the owner of a residential rental property, you may also qualify for many of the same tax breaks available to business owners. Rental property owners are, for example, generally permitted to write off the cost of advertising and marketing the rental property, office and computer-related expenses, mileage on travel to and from the residence, commissions to rental agencies, and payments to cleaning crews. Loss of rental income because the property is empty for a period of time is not deductible, but you can deduct expenses incurred while actively seeking a tenant.
Passive Loss Rules
There may, of course, be times, when the expenses associated with managing and maintaining the property exceed your rental income. Because income from rental activities is usually classified as passive income for tax purposes, deducting losses can be more complicated for landlords than for other business owners. Under the IRS’s passive loss rules, taxpayers are only allowed to offset passive losses against passive income from other sources, such as rental income from another property. The rules do not allow landlords to claim a passive loss against “nonpassive” income from a job or business, or against portfolio income from investments.
Depending upon your financial circumstances, you may, however, qualify for an exception to the passive loss rules. The IRS permits a deduction of up to $25,000 in passive losses by landlords who have a modified adjusted gross income (MAGI) of less than $100,000 and can demonstrate that they “actively participate” in the rental activity. Active participation generally means owning at least a 10% stake in the property and taking an active role in decisions relating to the management of the property, such as selecting tenants and approving repairs. The exception phases out gradually for landlords with MAGIs between $100,000 and $150,000. If your MAGI is above $150,000 and you have no passive income to offset a loss from your rental activities in a given tax year, you are permitted to carry over the loss to future tax years, when you may have positive passive income to report. You can also offset passive losses not allowed in previous tax years against gains from selling the property.
Despite these restrictions on claiming deductions for losses, collecting rental income does offer a distinct tax advantage over other types of earnings: Unlike active income from a business or job, passive income is not subject to payroll or self-employment taxes, which can run as high as 15.3%.
The tax implications of becoming a landlord will vary greatly depending upon your overall financial situation, the amount of income you can expect to receive from your property, and the amount of time the property is rented out to each tenant. For example, renting out a property for only part of the year or for only very short periods of time will affect the way you are taxed. Different rules apply to full-time real estate professionals than to part-time landlords.
Residential real estate can be a sound investment over time. But before deciding you are ready to take on the responsibilities that come with renting out a home, it is important to weigh likely expenses against potential income—and consider how your new identity as a landlord will affect you at tax time.