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Whether you intended to be a landlord or you fell into it because you had vacant property you couldn’t or didn’t sell, owning rental property is a source of income and it affects your tax return.
Knowing the rules can help you maximize the tax advantages of owning rental property and help you create a strategy to help lower your tax bill or defer some of your taxes.
Tax deductions and other benefits of owning rental real estate
If you’ve read “get rich” real estate books, a common theme is that rental property can help you save money on taxes.
The key is the depreciation deduction — a deduction you can take for a percentage of your basis in rental buildings each year.
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.
If you’re thinking you won’t take the depreciation deductions so you won’t have to recapture it when you sell, think again.
The IRS requires you to adjust your cost basis by your depreciation deductions or the amount of depreciation you could have deducted.
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!
If you can control when you sell a rental property, you might be able to sell it in a year when you are in a lower tax bracket, or when you are selling other assets at a loss.
Beware the passive activity and at-risk rules of investment property
The IRS generally considers rental income to be a “passive activity,” which is subject to special rules.
If you had a net rental activity loss, as is very likely with the help of the depreciation deduction, under passive activity rules, you can’t use that loss to offset your other taxable income, such as your salary.
If you (and your spouse if you’re married) actively participate in your rental real estate activity, however, you may get a special break.
Subject to income limitations, you may be able to deduct up to $25,000 of loss from the activity ($12,500 if you file as married filing separately and you lived apart from your spouse all year.)
You can use this loss to offset nonpassive income, such as your salary.
If you are a real estate professional and you meet certain requirements for time spent on rental activities, you may be able to treat your rental real estate activity as a nonpassive activity.
Likewise, if your investment is not “at risk,” meaning you cannot lose some or all of the money you have in it, you cannot take a tax loss of more than the amount you have at risk.
You probably don’t need to worry about this rule unless you have a more complex financial investment. Most small-time real estate investing would be categorized as fully “at risk.”
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.
Depreciation isn’t the only write off you can take
Rental property owners have the option of deducting more than just depreciation.
Here are a few examples of other deductible expenses:
- Advertising
- Auto expenses, either the standard rate of 56 cents per mile in 2021 (increasing to 58.5 cents for 2022) or your actual expenses, such as gas, oil, and depreciation
- Cleaning
- Non-mortgage interest, such as credit card interest on a card you use only for rental expenses
- Insurance, including fire, flood, liability and mortgage insurance.
- Legal fees and tax preparation fees related to your rental activity
- Maintenance
- Property management fees
- Mortgage interest (generally reported to you on Form 1098)
- Property and liability insurance
- Repairs, such as repairing the dishwasher, regular repainting, or fixing a roof leak
- Supplies
- Taxes
- Travel expenses when you travel overnight to improve property
- Utilities
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, 2021, for their January 2022 rent payment, you need to report that rental income with your 2021 taxes.
Unfortunately, waiting to cash the check until 2022 won’t help — you must report the income in the year the funds became available to you.
Follow special rules for 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.