Often the new military landlord doesn’t know what to expect for taxes, and it can be confusing. Here are some tips for when you’ve converted your home from your primary residence to a long-term rental property (some of this also applies to short-term rentals but there can be significant differences).
These tips assume you are retaining ownership of the property under your name or a single member LLC. Also, make sure you do your own research and don’t rely on this article for specific tax advice for your situation. Be aware that there are details beyond what is discussed here.
Yes, you can still do it on your own, but despite what the DIY software companies would have you believe, it isn’t simply a matter of answering a few questions to get it right. The more complicated your tax return, the more knowledge and research is needed to make sure it is right.
Besides the software, you should also follow the applicable IRS instructions and publications. If you are going to DIY landlord taxes, you have to be comfortable doing the reading and the research to get it right. The starting points for this are: the Schedule E Instructions, Publication 523, and Publication 527. If you aren’t willing or able to become your own tax expert, then you are better off hiring someone.
If you are going do the DIY route and you qualify to access Military OneSource, you can use their tax experts for free to get a little help.
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This starts with your final closing disclosure (CD) or HUD statement from the purchase of your property—the form at closing which listed costs and prices and divided them between seller and buyer. This is needed to help you determine your basis for depreciation, which we will discuss later.
The documents you need are documents that show any sources of income (usually the rent paid) and any possible deductions. The deduction categories commonly used can be found on the Schedule E Form, and that can be used as a guide for what documents you should retain.
Here is a list of the most common deductions for which documentation should be retained and which will be reported on the Schedule E:
Anything you pay for advertising or marketing is deductible, like when you pay to advertise on MilitaryByOwner.
This one is often missed by new landlords. If you travel to and from the rental property for valid business reasons, it is a deduction. Travel for inspections, house showings, and doing repairs are good examples. For your own vehicles, track mileage and actual costs. You’ll always want to track mileage to prove the percentage of business use.
Most landlords take the standard mileage deduction, but in some cases taking actual costs as a deduction can be better. It is a good practice to track both. It is also a good practice to record the mileage for vehicles on January 1st of each year and whenever you purchase a new or new to you vehicle.
To show the percentage of business use for a vehicle, you need both business miles and personal miles. If you are traveling long distances, you may be able to claim airline ticket costs, meals, and hotel stays. Note that mixing business and pleasure has special rules. You can find more information about auto and travel deductions in Publication 463.
Only the portion of the mortgage payment that goes to interest is a deduction, not the portion that goes to principal. What actually gets paid to your insurance company and what actually gets paid for your real estate taxes is a deduction—not what you pay to an escrow account. The deduction for real estate taxes and insurance happens when a payment is made from an escrow account or if you make the payment on your own.
Keep receipts and invoices for cleaning, maintenance, repairs, insurance, property management fees, HOA fees, repairs, improvements, real estate taxes, supplies used for the property, and utilities.
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For a rental property converted from a primary residence, the basis for depreciation is the lower of your adjusted basis or the fair market value of the property when it is placed into service as a rental.
First, you determine the basis you started with. Most of that basis is based on the purchase price. Pub 527 and Pub 946 and Pub 523 provide some guidance on how to determine the basis, as well as Pub 551, Basis of Assets.
Some closing costs can and should be added to the basis. The land portion of the basis is not depreciated. To determine your adjusted basis, add the costs of any improvements, but not repairs. There can be subtractions that reduce basis, but that isn’t common with a converted property starting out. The three pubs just mentioned provide some guidance on what is an improvement versus what is a repair. More on that later.
Once you have the adjusted basis, you compare that to the fair market value and choose the lower of the two as your basis to be used for depreciation, with just one more bit of math. The basis that is attributed to the value of the land cannot be depreciated, so the land basis has to be subtracted out before depreciation is calculated.
The IRS assumes the value of assets other than land go down over time. Essentially, they get used up. The IRS allows you to take a deduction for this depreciation for any physical business asset that you retain for a year or more and that has an expected life of a year or more. The IRS has decided that residential rental property (structures or buildings) is depreciated over 27.5 years. So if the basis for your residential rental property is $27,500, then you get roughly a $1,000 deduction every year.
Besides the rental property, structural things like flooring, appliances, and even furniture may be depreciated. Land improvements like fencing are often depreciated. In some cases, lower value assets may be expensed in one year and in some cases depreciation can be accelerated. It can be complicated. A good resource is the IRS tax topic on Depreciation, which includes reference to helpful publications.
Sometimes taxpayers get the idea that depreciation is complicated, so they just won’t do it. That idea doesn’t work for depreciation. When you sell the rental property, the IRS expects you to pay taxes on the depreciation taken or allowed. You can think of this as the IRS catching up on the taxes you didn’t pay earlier due to the depreciation.
But even if you didn’t take the depreciation and get the tax benefit over the years as a rental property, then you still have to pay depreciation recapture—the gain associated with depreciation since depreciation lowers your basis. Even if your capital gains are excluded on the sale of the property, depreciation recapture usually still applies. There are ways to correct the error of not taking depreciation. There are ways to defer or offset depreciation recapture, the most common method being a 1031 exchange.
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Generally speaking, an improvement increases the value of the property. These things are often depreciated, although as mentioned above, there can be special rules. Repairs fix something so that it is in working order. Repairs should generally be expensed or deducted. Some examples:
Pub 527 discusses the difference between improvements and repairs, and it also provides examples.
Most folks don’t know all the ins and outs of the capital gains exclusions for the sale of a property that was your personal residence. If you are doing your taxes DIY, make sure you are diligent on the research in this topic. This means not only reading Pub 523, but also at the very least 26 US Code Section 121.
Please note that folks still get this wrong, even when they use those two resources. If you have any doubt, consult a tax professional. It is worth paying a few hundred dollars to avoid an error that can cost you thousands of dollars. Two good articles to read on this topic:
Watch a quick synopsis of the above tax tips: