If you took the plunge into real estate investing, you probably did so intending to create passive income. With the demands of military life, it can be difficult to create opportunities for additional income, and a rental property is the perfect way to do just that!
But just like your primary source of income, your rental income is taxable. The good news is, your transactions with the IRS aren’t as cut and dry as they might appear.
So, let’s talk about how to preserve your profits and make the most out of your real estate investment!
What to Know About Investment Property Taxes (and How to Avoid a Tax Hit When You Decide to Sell)
1) What does the IRS consider taxable?
Anything considered rental income is taxable by the IRS. It sounds simple enough, but it includes more variables than the standard monthly rent check. Some things to look out for:
- Advance rent. Any rent the tenant pays before the time it covers is advanced rent. For example, if your tenant signs a three-year lease and pays the $2,000 for their first-month rent and another $2,000 for the last month’s rent, you’re required to claim all $4,000 under this year’s income.
- Security deposit. You don’t need to claim a security deposit on this year’s income if you plan to return it in full. However, if you use any or all of it to cover damages created by your tenant, you are required to claim it in the same year that you spent it.
- Pet deposit. The same goes for a pet deposit. A non-refundable pet deposit should be claimed the year you receive it. However, if you plan to return it at the end of the lease, you only need to claim it as income if you spend it.
- Payment to cancel a lease. If your tenant pays to cancel their lease prematurely, it’s taxable.
- Services received. If a tenant takes responsibility for a repair or improves the property by painting, landscaping, etc. in exchange for rent, then you must include the amount of rental income your tenant would have paid as income. For example, the tenant and you agree that they’ll paint the exterior of your home in exchange for two months' rent. You’re required to claim the two months' rent as part of your taxable income.
2) Which parts of your real estate investment are tax deductible?
The IRS notes that rental property investments have a safe harbor, meaning that real estate properties used to generate rental income are “to be treated as a trade or business for purposes of the qualified business income deduction under section 199A of the Internal Revenue Code.”
As dry as it sounds, it’s exciting news! Why? Because it opens the doors to a greater number of deductions, preserving that sweet rental income you’ve nurtured into growth.
Depreciation. In How Rental Property Depreciation Works, Jean Folger shares that “any residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting technique that spreads costs (and depreciation deductions) over 27.5 years, the amount of time the IRS considers to be the ‘useful life’ of a rental property.”
In the most basic sense, this means that you take the tax assessor's appraisal and divide it by 27.5 for your depreciation deduction. Take this scenario from Fox Business as an example. Say that you paid $200,000 for your rental property. The tax assessment for the land is $75,000 and the building is $125,000. To calculate depreciation for rental property purposes, you’d simply divide 125,000 by 27.5 to get your depreciation expense of $4,545 multiplied by your marginal tax rate each year.
Having said that, the actual savings part can get a little tricky, so it’s best to hire a tax professional for assistance.
Interest. Just like any borrowed money, the mortgage you took out to purchase your rental property or the loan you acquired to make improvements has interest rates. Thankfully, this interest is deductible. Another type of tax-deductible interest is on credit cards used for goods and services associated with the rental.Pass-through tax deduction. In Top Ten Tax Deductions for Landlords, Nolo shares that “most landlords will qualify for a new pass-through tax deduction established by the Tax Cuts and Jobs Act. This deduction is a special income tax deduction, not a rental deduction. Depending on their income, landlords may be able to deduct (1) up to 20% of their net rental income, or (2) 2.5% of the initial cost of their rental property plus 25% of the amount they pay their employees.”
Note: this deduction is scheduled to expire after 2025.
Travel. Long-distance landlords everywhere are praising this deduction. Since the IRS treats real estate investments like businesses, travel costs associated with maintaining the property are tax deductible. That means that all or portions of airfare, hotels, meals, gas, car rental, or mileage can help you get a tax break.
Keep records of your receipts. And if your travel isn’t solely rental property-related, then it’s always a good idea to work with a tax professional.
Legal fees and professional services. Your investment adviser, property management company, accountant, and tax professional’s fees are included under operating expenses, and are therefore tax-deductible.
Ordinary and necessary expenses. It takes a lot to keep a rental property up and running. Thankfully, many of these expenses are deductible, such as the following:
- Marketing: the cost to create a stellar home advertisement and put it on the market.
- Cleaning and maintenance: the cost of carpet cleaning, professional cleaning, lawn care, plumbers, handymen, etc.
- HOA fees: There’s no way around them, so HOA fees are considered necessary expenses and are deductible.
- Property taxes.
- Utilities that you cover: You might choose to leave a handful of utilities under your name instead of transferring over to the tenant, and those qualify you for a tax break.
- Repairs: This includes the cost of materials should you choose to make repairs yourself or independent contractor's fees to do the work.
- Insurance claim deductibles.
Repairs and improvements. While repairs and improvements made to the property are tax deductible. there are a couple of different ways to claim them.
- If they’re minor and don’t add much value to the home, then you can deduct them the same year you make them.
- If they’re major improvements like renovations or a new roof that add a substantial amount of value to the home, then you would add the expense to the home’s cost basis and take it as part of the annual depreciation deduction.
3) How to avoid a tax hit when selling your rental property.
When it comes time to sell, you want to walk away with as much financial growth as you can. Part of accomplishing this is anticipating the variety of expenses you’ll face.
Depreciation recapture. While depreciation can provide a bit of a tax break, there’s a less fortunate side of the equation.
Matt Frankel, CFP says, "As long as it’s properly maintained and cared for, real estate doesn’t get ‘used up.’ Quite the opposite--real estate values tend to go up over time, not down. For this reason, if you end up selling an investment property, the IRS wants its depreciation benefit back. This is known as depreciation recapture.”
For example, you bought for $150,000 and are selling for $200,000. Over the last several years. you took $7,000 in depreciation deductions. The $50,000 you make from the sale is considered capital gain — which is taxable and also known as capital gain tax. And the $7,000 you took in deductions falls under taxable income.
Capital gains. Capital gains are what you’ve been working for and served as the light at the end of the tunnel when you struggled with your tenants a few years back. And, if you play your cards right, it’s a nice chunk of money.
So, how can you avoid hemorrhaging money to the IRS? Jim Probasco has a few ideas:
- Make your rental property your primary residence. You might already know that when you sell a primary residence, you gain the opportunity to exclude up to $500,000 from the capital gains (check out The Effect of Capital Gain Tax Exclusion on Military Home Sellers for more details and eligibility). This means that if you can turn your rental property into a primary residence long enough to meet the capital gains tax exemption requirements, you could walk away with a larger profit. However, this measure can be hard to pull off if you’re active duty military.
- Buy another investment property. Section 1031 makes it so that you can defer the capital gains from one rental sale if you turn around and invest it into another investment property.
- Tax-loss harvesting. Have you ever heard of it? Tax harvesting allows you to pair the gain of your home sale with the loss of other investments. For example, if you’re profiting $30,000 in capital gains with the sale of your rental home, but lost $40,000 to the stock market this year, you can offset the capital gain making $30,000 a wash.
While you must understand taxes associated with your rental property, you should always consult a tax professional to help you navigate claims with the IRS. A trained accountant will help ensure that you not only get the most out of your investment, but also stay within the bounds of tax laws.