Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
Some time ago real estate offered many tax advantages. You could deduct all your losses against ordinary income and property could be depreciated at a faster pace while depreciation recapture escaped taxation when the property was sold. In addition, there were a number of other benefits. Much of that has changed now. The benefits haven't been eliminated, they've just been cut back. That means if you're looking to make a good return you'll have to rely more on the property generating income and less on the tax benefits.
Passive Activity Losses in General
This is the big restriction and will affect virtually all investors. Real estate is an inherently passive activity, as opposed to a business such as a manufacturing operation, restaurant, etc. Beginning in the late 80's tax law restricted deductions for passive activity losses such that they could only be used to offset passive activity income. Fortunately the law carved out a number of limited exceptions. Two of the most important exceptions involve "active participation" in a real estate activity and the use of the losses on the disposition of the property.
The active participation rule allows an individual who "actively participates" in the management of the property to deduct up to $25,000 of losses against ordinary income in any one year. But there's a restriction on the exception. The $25,000 allowance is phased out as your modified adjusted gross income (MAGI) increases. (Modified adjusted gross income is adjusted gross income figured before any passive activity loss, taxable social security benefits, and certain other adjustments. See IRS Publication 527.) You lose $0.50 of the $25,000 allowance for each dollar your MAGI exceeds $100,000 until at $150,000 the allowance is completely gone. (The $25,000 allowance is reduced to $12,500 for taxpayers filing married, separate.)
Meeting the active participation requirement is far easier than the "material participation" requirement of other activities such as an S corporation business. All you need do is make management decisions in a significant and bona fide sense. For example, approving new tenants, deciding on rental terms, approving expenditures, and similar decisions. In many cases renting your Florida condo can qualify, even if you have a management company taking care of the details. You do need overall control. And you must have at least a 10% (by value; your spouse's interest is added to yours) interest in the activity throughout the year. That's rarely an issue for small properties such as a house, condo, etc.
But the allowance may not be of much current value. You won't be able to deduct net losses if your MAGI exceeds $150,000--when they'd be most useful as you're in a higher tax bracket. Should your business have a bad year and your MAGI is only $75,000, you'll be able to deduct any accumulated unused losses, but they'll be worth less since you'll be in a lower tax bracket. Heads the government wins; tails you lose. If the rental is profitable, you'll be taxed on the income. If the income exceeds the threshold, you may also be subject to the 3.8% net investment income tax.
Income and losses from multiple passive activities offset each other. The $20,000 loss on a house rental can be used to offset the $26,000 of income from the rental of the small office building you own. Thus, you'll report $6,000 of passive income. Any unused losses aren't lost, but deferred until you can use them against ordinary income (e.g., your MAGI is low enough), you have offsetting passive income, or you sell your entire interest in a property. The benefit of the losses isn't gone, it just means you may not get the maximum benefit and you may need some good tax planning.
For example, most rental properties tend to generate losses in the initial years, but as rents increase and mortgage interest and, possibly other expenses, decrease, properties become profitable. For a time the profits might be used to offset accumulated losses, but when the properties start to generate a net profit you might further defer the income by investing in another property.
Those are the basic rules. IRS Publication 925 contains more of the details--and it's 29 pages long. We can't go into the detail here, but we will discuss some of the more commonly encountered special situations.
Rentals with Nonpassive Income
Certain activities that would, on the surface, appear to be passive, may not be. Again, we'll only discuss issues that you're likely to encounter. In the situations below, any net income generated from the activity would be nonpassive. Losses, however, would be passive. Your tax adviser or preparer will be looking for these nonpassive rentals when he prepares your return.
Rental to nonpassive activity. Many business owners who own the building from which they do business hold the property in their own name or a separate entity and rent it to the business. It makes sense from a legal and financial planning standpoint. Should the business go bankrupt, you decide to sell, or you just want to pass the business to your children but want to retain the real estate, you should have the real estate in a separate entity. But any rental income generated by the property would be nonpassive and can't be used to offset passive losses.
Example--Sue owns Madison Inc., an S corporation that does medical testing. She is a 70% shareholder and materially participates in the business. She owns the building through an LLC and charges Madison rent. The rental activity produces net income. The income is not passive and can't offset passive losses from another activity.This is an important point for many business owners. It can get more complicated if you rent part of the building to your business and the rest is rented to unrelated parties.
Rental where less than 30% depreciable. Income from property rental where less than 30% of the unadjusted basis of the property is subject to depreciation is not passive income. An example is the simplest way to explain. For $625,000 Fred and Sue buy a 5-acre tract of land with a house next to a shopping center. They rent the house and land, hoping to defray the costs of holding the property. An appraisal shows the land is worth $500,000, but the house is only worth $125,000. Since the land is not depreciable, the depreciable portion of the property is less than 30% of the total.
Other situations. There are several other situations that could produce nonpassive income, not all of them relate to rental real estate. They include significant participation passive activities, equity-financed lending activities, rent of property incidental to development activities, and licensing of intangible property by pass-through entities.
Nonpassive Rental Activities
This category is different than the special situations in the group directly above. These activities aren't considered nonpassive real estate rentals for either income or loss purposes.
Tangible personal property. Renting tangible property such as farm equipment, etc. doesn't fall under the real estate umbrella. On the other hand, the rental of a home with appliances such as a stove, dishwasher, etc. clearly is rental real estate. Renting a furnished house or condo also qualifies as a real estate rental. Things can get trickier if you're renting commercial property such as a auto repair facility containing equipment. The crossover point depends on the facts and circumstances.
Material participation. In some cases you may qualify as materially participating in the rental real estate activity. For example, you own five rental homes and you spend more than the requisite amount of time managing the properties, doing repairs, looking for new ones, etc. In that case the income or losses are not passive. Thus, the losses are deductible against ordinary income and without respect to the $25,000 allowance. It's called qualifying as a real estate professional. To do so you must show you spent more than half of the personal services you performed in all trades or businesses during the tax year in real property trades or business in which you materially participated and you performed more than 750 hours of services in real property trades or businesses in which you materially participated. For example, you're a contractor, property manager, etc. But that work only qualifies if you are a 5% or more owner in the business.
Example 1--Sue is a part-time drug salesperson. She works about 30 hours a week at the job and has five rental properties where she spends over 750 hours a year. She doesn't qualify because she didn't spend more than half of her time working on real estate.
Example 2--Sue's sister, Jill is in the same situation, but she's semiretired from the drug company. She works only 5 hours a week for the company, doing consulting work. She qualifies and can deduct the $55,000 in losses generated from her properties.Caution. It's tough to qualify for this exception, and the IRS is applying extra scrutiny to returns claiming real estate professional status. You'll have to document carefully the time spent on the property.
Average rental 7 days or less. An activity is not a rental activity if the average period of customer use of the property is 7 days or less. The average is computed by dividing the total number of days in all rental periods by the number of rentals during the tax year. You can encounter this situation if you rent a property in a vacation area. Rentals in some areas such as ski resorts, beach homes, etc. are often rented for a week of six days with the seventh day used by the owner for cleaning. As a result, such a rental is a passive activity and not a rental activity and doesn't qualify for the $25,000 allowance.
The activity is not a rental activity if the average use of the property is 30 days or less and you provide significant personal services with the rentals. The most common situation is a bed and breakfast. That's really a trade or business.
Exactly where these activities fall will often depend on the facts and circumstances. If you're in such a situation, discuss it with your tax advisor.
There are a number of other points to consider before purchasing a rental property. We won't discuss the details here, just the important points. You can get more information in IRS Publication 527.
Depreciation. This is an important factor when considering a rental. It will reduce your net income (or increase your loss), yet it's not a cash outlay. When you sell the property you may have to recover the cost, in part or in whole. Called depreciation recapture (technically unrecaptured Section 1231 gain), it's taxed at ordinary income rates, but no more than 25%. (There's an example in the next topic.) Depreciation can be taken on the building, but not the land. For residential rentals, the building cost is recovered evenly over 27.5 years. For nonresidential property (office building, retail store) the recovery period is 39 years. You can depreciate other property in the building such as carpeting, appliances, etc. over a much shorter period, usually five or seven years.
You should know a couple of quick rules on depreciation. First, you can only depreciate the building, not the land. In most cases the cost is not split between the two on the purchase and sale agreement. You'll have to use the local tax assessor's split between the two. If you don't have that, you'll need an appraisal. If you purchase furniture or other tangible property (e.g., snowblower, garden tractor) along with the property, use a separate bill of sale. You can depreciate these items much quicker, so it's to your advantage.
Second, if you don't purchase the property but acquire it in a different fashion, your basis for depreciation or gain or loss may be computed under a different rule. For example, you purchased a home for $50,000 some 20 years ago and used it as your principal residence. You've moved into a condo and begin renting the home. Your basis for depreciation is the lesser of the fair market value or your purchase price (plus any improvements). Assuming no improvements, your basis will be $50,000, even if the fair market value now is $300,000. It can get more complicated. If you deferred gain on the sale of a prior home to buy the house (the pre-1997 rules) you'll have to lower your basis for the deferred gain. Do a like-kind exchange on another rental or investment property to get the current one? Acquire the property as a gift from a relative? Both scenarios come under different rules. Inherit the property? Your basis is the fair market value at the time of the prior owner's death. Best to get professional advice here.
Capital gain, loss, and depreciation recapture. Good news and not such good news here. If you sell the property at a profit, you'll generate a capital gain which is taxed at more favorable rates--0% if you're in the 10% or 15% bracket, 15% in other brackets, except if you're in the top bracket of 39.6%. There the top rate is 20%. You may be subject to the 3.8% net investment income tax if your AGI is more than $200,000 ($250,000, married filing joint).
Depreciation taken on the property may be subject to recapture at ordinary income tax rates, but no more than 25%.
If you have a loss from the sale of the property it can be used to offset ordinary income rather than capital gain.
It sounds more complicated that it is. A quick example will help.
Example--Fred and Sue purchased a two-family house in a residential area for $300,000 in 2010. They've taken $40,000 in depreciation on the property over the years (we'll ignore any land value to keep it simple) and sell the property in 2014 for $350,000. Their adjusted gross income is $275,000 for the year. Their adjusted basis in the property is $260,000 ($300,000 less $40,000). Part of their "gain", $40,000, is depreciation recapture (technically unrecaptured Section 1250 gain) which is taxed at 25%. The additional gain of $50,000 is taxed as a long-term capital gain at 15%. Fred and Sue are also subject to the 3.8% net investment income tax on the long-term capital gain of $50,000.It's more in taxes than they would have paid some years ago, but they did get a tax advantage. The lower tax rate on the $50,000 capital gain is obvious. The 25% depreciation recapture may or may not be a benefit. They got an ordinary income tax deduction for the depreciation, but are repaying it at no more than 25%. If they were in a higher bracket when they claimed the depreciation, they're coming out ahead. If they're in the 25% or higher bracket today and they deducted the depreciation when they were in the 15% bracket, they're coming up short on the deal.
There may be alternatives. You may be able to do a like-kind exchange to avoid current tax consequences, deferring the gain to later years when you might be in a lower bracket. You might also be able to do an installment sale, spreading the gain over several years.
Hobby loss rules. If you engage in an activity without intending to make a profit, the IRS can disallow your losses. That most frequently happens in activities with a "recreational" component such as horse breeding, auto racing, etc. While it's less likely to happen when renting property, the activity isn't immune. (For a detailed discussion, see our article Hobby Losses.) When the IRS has attacked rental properties it's because the property has been vacant for an extended period of time (more than the market would indicate), the rents have been far below market, etc. Since the consequences can be costly, get good advice if you think you'll be in such a situation.
Related party rental. You can rent the property to your sister and brother-in-law, but you've got to charge them a fair market rental. If you don't the losses can be disallowed. Talk to a real estate agent concerning the rents in your area. Same is true for renting to your business.
Debt financing and interest costs. One of the big advantages of investing in real estate is leverage. You can buy a property for only 20% down in most cases. That can result in significant profits, particularly when interest rates are low. Interest expense to purchase a property or for improvements on the property such as redoing the kitchen and bath, are deductible on Schedule E (rental income and loss) of your tax return.
But interest on money taken out in a refinancing or taking out a loan on the property after a cash purchase, isn't directly deductible. The deductibility of the interest then depends on the use of the proceeds. For example, you purchase a rental home for $250,000 by taking out a $100,000 loan and paying the rest in cash. Two years later you find you need $50,000 for a new car. You refinance the loan for $150,000, repaying the outstanding principal and taking out $50,000 for the car. Only interest on the original $100,000 is deductible. Use the extra $50,000 for redoing the kitchen on the property? All the interest would be deductible. Use the $50,000 to buy an additional rental property? The interest would be deductible, but not on the first property.
If you know you'll need some funds down the road, it may be best to consider that when financing the original purchase. That is, put down less cash, saving it for future use.
Vacation home. If you own a "vacation property" such as a home on a lake, condo in a ski resort, beach house, etc. that's rented for a month at a time or for the season, you can treat it like any other rental property if you don't use the property for personal purposes during the year. If you use it for personal purposes more than the greater of 14 days or 10% of the total days it is rented to others at a fair rental price you're considered to have used the property as a home during the personal use and your deductions will be limited. If you have a net loss, the loss is not deductible as a passive activity loss but can be carried forward and used in subsequent years to offset rental income from the property. This can be a complicated issue. Unless you intend to use the property only a de minimus amount of time, consider rental income as simply a way of defraying some expenses on the property.
Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 11/06/14