After building an emergency fund and maxing out tax-advantaged retirement accounts like 401(k)s and IRAs, some investors find themselves contemplating the purchase of a rental property to continue building their net worth.
Adding a rental to your investment portfolio offers an opportunity to generate a “passive” stream of income and build equity over time. We put passive in quotes because depending on the situation, it may still require a decent amount of work or a decision to cut into the income stream to hire someone to be a property manager.
Logistical work aside, before you make the leap to becoming a landlord it’s important to understand the tax implications of buying a rental as well.
As with most types of investments, there are tax benefits and drawbacks to owning a rental property. In this article, we’ll explore both.
Let’s dive in.
Potential Tax Benefits of Owning Rental Property
Tax Deductions
If you itemize your deductions at tax time, you’re probably familiar with Schedule A, which allows you to claim property tax and mortgage interest deductions on your primary home.
Investing in a rental property gives you an opportunity to claim even more tax deductions to reduce your taxable income.
Deductible expenses include liability insurance premiums, mortgage interest, real estate taxes, and homeowners’ insurance premiums for the rental plus costs related to owning, maintaining and managing the property, such as cleaning fees and repairs like fixing a leaky faucet.
Claiming these deductions is easy. Report them on Schedule E, where you list the rental income the property generates.
1031 Exchange
If you choose to invest in a rental, there may come a time when you want to sell it and use the equity you’ve accumulated to purchase a new property.
If your existing property has appreciated in value and you will be purchasing a new new property that costs the same or more than the old one, you may be able to defer paying capital gains taxes generated by the sale of the rental by using a transaction known as a 1031 exchange. .
To qualify as a 1031 exchange, you must complete the sale of the old and purchase of the new property within a specific window of time and have a qualified intermediary help facilitate the transaction.
A 1031 exchange can be complex, so it’s a good idea to consult with a tax advisor before completing one.
Cash Flow and Asset Appreciation
If you stick with it for the long haul, a rental property can be a profitable investment in two ways.
First, it has the potential to pay for itself (at least partially) and improve your cash flow by generating rental income.
Second, because real estate typically appreciates over time, the value of the property will likely increase.
Personal Enjoyment
Your tenants aren’t the only people who can take advantage of your rental property. You can use it too within certain limits (more on that later) while maintaining some or all of the tax benefits and improving your cash flow.
You may also choose to convert the rental to a personal use property in the future for you and your family to enjoy.
Potential Tax Pitfalls of Owning Rental Property
Recordkeeping Requirements
If you want to take advantage of all the tax deductions available to you, keeping accurate records detailing the income the property generates and expenses you pay to maintain it is crucial.
Liability
Holding a rental property in a limited liability company (LLC) is generally recommended to minimize the risk to your personal assets if you are subject to legal action resulting from your ownership of the property.
LLCs are disregarded for tax purposes under federal and most state laws if owned by a single individual or entity. However, creating one may require the help of an attorney or tax professional, and some states require LLC members to complete an annual registration.
Keep in mind that in order for the liability protection of an LLC to be available, all financial matters related to the rental property needs to be under the umbrella of the LLC.
This means rent should be paid to the LLC, expenses should be paid from the LLC and all building insurance and titling should be in the name of the LLC. Additionally, if an LLC has multiple members, it will be treated as a partnership, and you’ll need to file an extra tax return.
Limited Availability for Personal Use
Personal use of the rental may affect the deductions you can claim on your tax return.
To maximize your deductions, you can only use the property for 14 days each year or 10 percent of the total time it’s rented annually—whichever is less.
If you use the property more than that, you won’t lose all the tax benefits. However, you’ll only be able to deduct a portion of certain expenses.
Here’s how it works:
Costs related solely to rental use of the property, such as cleaning fees you incur at the end of each rental period, are fully deductible.
However, expenses like insurance and real estate taxes are only partially deductible because they apply to both rental and personal use of the property.
In that case, you must allocate part of the expense to the rental activity and part to personal use. The portion of the cost allocated to rental usage is deductible, and the portion allocated to personal use isn’t.
Depreciation Recapture
When you own a rental, you’re required under the tax code to depreciate the property each year, which you can claim as a deduction on your tax return.
Because you get to deduct depreciation for as long as you own the property, you’re subject to a depreciation recapture when you sell it (unless you’re completing a 1031 exchange).
That means all or part of the gain you earn on the sale of the property is subject to federal taxes at a rate of 25% instead of the more preferential long-term capital gains rate.
Here’s how it works:
Let’s say you purchased the property for $275,000 and claim annual depreciation deductions of $10,000 for five years for a total of $50,000. After five years, you sell the property for $400,000.
Before you can determine your realized gain, you need to calculate the adjusted cost basis of the property, which is equal to the purchase price (plus improvements) minus accumulated depreciation. In this example, that would be $225,000 ($275,000 - $50,000).
When you sell the property, the realized gain equals the sale price minus the adjusted cost basis or $175,000 ($400,000 - $225,000).
Of the $175,000 realized gain, $50,000 (accumulated depreciation) is subject to depreciation recapture and taxed at 25%, and the other $125,000 is subject to capital gains tax rates.
You’re subject to depreciation recapture even if you (incorrectly) did not deduct depreciation on your tax returns when you owned the property.
If you haven’t been deducting depreciation on your rental, it’s possible to correct the error, but you should consult with a tax advisor because the way you resolve it depends on how long it’s been going on.
Some taxpayers are also subject to a Net Investment Income Tax (NIIT) when they sell an investment property. If your modified adjusted gross income (MAGI) is above the threshold set by the Internal Revenue Service (IRS), you must pay an additional 3.8% tax on the realized gain.
Limited Rental Losses
Because you can deduct depreciation, repair bills, mortgage interest, real estate taxes, and other operating expenses related to owning and managing a rental, it’s not uncommon for rental property owners to experience rental losses.
However, you may not be able to claim all losses as deductions when filing your taxes. Here’s why.
Rental losses are typically considered passive losses that can only be offset with passive income. If you don’t have passive income to offset the losses, you can’t deduct them on your tax return.
The good news is that they’ll continue accumulating, and you can carry them forward until you have income to offset the losses or you sell the property—unless you’re completing a 1031 exchange.
Generally, passive losses aren’t released after a 1031 exchange until there’s a taxable event, such as realizing a taxable gain or loss.
However, there’s an exception for individuals who have an adjusted gross income of $100,000 or less. These individuals may deduct up to $25,000 in losses even if the income they are using to offset is not passive.
Conversions are Complicated
Finally, be aware that converting a rental property to a personal use property (or vice versa) can be complicated from a tax perspective. Understanding the rules and working with an experienced tax professional is crucial to avoid costly mistakes that can increase your tax bill, including past returns if you fail to claim appropriately to start.
Next Steps
If you’re at the point in your financial journey where you’re considering purchasing an investment property, you can likely benefit from working with a financial advisor who can provide tax projections and strategic tax planning services as part of a comprehensive wealth management plan.
A good financial advisor can also help you compare the rental property option with other ways to generate passive income and build your net worth.
Take our 2-minute analysis for an instant gut-check of how your current tax strategy stacks up and see if working with a pro may be right for you.
