People love real estate, whether it’s their own home or buying rental property.
Even if you don’t own your primary house or second home, you have probably heard somewhere that owning them is a surefire way to become rich.
While owning a rental property is one way to kickstart the wealth-building process, we think it’s imperative to fully understand what you are getting into. Namely, get a firm grip on the all-in costs, realize which expenses are deductible (or not), and other tips to manage it effectively.
Today we’ll review some of these important factors.
Understand the Expenses that Offset Rental Income
Schedule E of the tax return will report all of the rental income and expenses. Note that this is considered “passive income” and not “earned income” like wages are. As such, only passive losses can offset passive gains. You cannot use passive losses to offset your job income, nor for investments or dividend income.
Depreciation deduction is one of the biggest offsets. This is a deduction you can take for a percentage of the basis in the rental property each year. Your purchase and any improvements to the property is a deduction expense spread across the useful life of the property. Typically, for residential real estate, this is 27.5 years. Your CPA can offer more insights on how this works and the particulars.
When you sell the property, all those depreciation deductions have reduced your basis in your property. Your profit when you sell is equal to your selling price, minus your adjusted basis.
You get the tax benefits of depreciation deductions while you own the property, but when you sell, you generally pay tax on the gain you would have had, plus all those depreciation deductions you took.
Even if depreciation deductions basically push some tax liability to future years, that’s not all bad. The longer you keep your money, the more it can work for you!
Other Deductible Expenses
There are many common deductible expenses that can work in your favor, including:
- Advertising (including listing fees to advertise your rental)
- Auto and travel (managing your rental; get 58.5 cents per mile in 2022)
- Insurance (homeowner’s, fire, flood)
- Legal and other professional fees (CPAs, lawyers, real estate agents, etc.)
- Maintenance & Cleaning (keep rental in good shape)
- Management fees (rental agencies and property management companies)
- Mortgage interest (commonly on Form 1098)
- Property Taxes
- Repairs (repair dishwasher, fix roof leak, etc.)
- NOTE: you do not deduct “home improvements” – that is considered depreciation expense.
Determining Eligibility for a Qualified Business Income Deduction
The qualified business income deduction (QBI) is a tax deduction that allows eligible self-employed and small-business owners to deduct up to 20% of their qualified business income on their taxes.
Landlords may assume their rental income can qualify for this deduction; however, passive rental activities are not considered a trade or business unless they are a RREE (rental real estate enterprise). Be sure to confer with your CPA on if the QBI will be a deduction you can count on.
High adjusted gross income can mean no rental property loss deduction
If your modified adjusted gross income (MAGI) is between $100,000 and $150,000 or higher ($50,000 and $75,000 if married filing separately), your maximum allowable loss is reduced.
You cannot take a special allowance for a rental real estate loss if your MAGI is over $150,000 ($75,000 if married filing separately).
You can carry any unused loss forward until you have a year with a lower adjusted gross income, or until the year you sell or otherwise dispose of the property.
You may be wondering how can I keep track of all the incomes, expenses, and home improvements, etc? The answer is bookkeeping, the holy grail of a smooth tax season!
In order to prove that you qualify for the aforementioned tax benefits, you need to keep records of everything, including receipts, invoices, and rent collection. A great way to do this is by investing in bookkeeping software. An online search will turn up plenty of them.
Other low-cost property management software for landlords include Cozy, Housters, Rentler, Stessa, and TenantCloud. The options are endless, but as a best practice you should have something in place.
A Couple More Tips
Separate Accounts. Be sure to keep a separate account where all your income and expenses come out of as this helps prevent “commingling of assets”.
If you treat your business’ money the same as your own, then you risk the exposure of your personal assets in a lawsuit (even if you have an LLC). The IRS may also try to deem certain business expenses as personal during a future audit if you aren’t careful.
Timing is everything. If you’re on a cash basis, as most individual taxpayers are, you report income when you receive it. This is true regardless of the period to which the rent applies.
For example, if your tenant pays you on Dec. 30, 2022, for their January 2023 rent payment, you need to report that rental income with your 2022 taxes.
Unfortunately, waiting to cash the check until 2023 won’t help — you must report the income in the year the funds became available to you.
Security deposits. Special rules apply in the handling of security deposits. If you receive a security deposit that you expect to return to the tenant, do not report it as income. If a deposit is nonrefundable, on the other hand, you must report it as income when you receive it.
Know the Potential Downsides. There are numerous potential drawbacks to owning rental property. Primarily, being a landlord isn’t for everyone. Conflicts may arise, things change, and tenants can be difficult. Property requires constant upkeep, repair, and maintenance. And if you are in a cash crunch, the lack of liquidity (could take months to sell) can become a hinderance. I won’t expand beyond this summary, but please be aware of the pitfalls.
I’ve said this before, but at TrustTree Financial – we love a good plan! Failing to plan is like planning to fail.
If owning a rental property is a dream of yours, consider the above information before going down that path. It’s like owning any other asset. You should be aware of the tax implications, liabilities, and pitfalls before making the purchase. This will lead to a better experience and ensure you are better prepared leading up to tax time.