Holding rental property is an attractive way to earn passive income. This monthly income is also very tax advantaged, implying there are various approaches to offset the taxes you would otherwise pay on this income.
Depreciation is one such example and a concept that most people already understand. In short, depreciation is a deduction or discount that owners can take over many years. For residential assets, depreciation is taken over a 27.5-year period, which the IRS acknowledges as a residential building’s “useful life.” I.e., a rental facility with a cost basis of $300,000 would produce a deduction of $10,909 per year ($300,000 / 27.5 years), which can, in turn, be used to counterpoise your taxable income. You can write-off or take depreciation even if your property is technically profitable and increasing in value.
But there are other nuances to how rental real estate income is taxes—nuances that are not as well understood by most everyday investors.
In this two-post series, we take a glimpse into how real estate income is taxed. As you will certainly see, there is a spectacular benefit to becoming a designated “real estate professional.” We’ll study the benefits of this designation carries and how you might be able to qualify.
An Overview of How Real Estate Income is Taxed
For now, let’s assume that you are not a “Real Estate Professional” according to IRS standards. You are an individual who works their 9-to-5 in an office environment, managing your rental assets on an as-needed basis. This designates you as a “Passive Real Estate Investor,” which is the same with most who buy rental properties.
Passive real estate investors should presume to be taxed as follows:
Taxed as Ordinary Income: Any income earned thru rental profit is deemed “ordinary income,” implying that you will be taxed according to your tax bracket. High-income-earning professionals tend to be in higher tax brackets and can consequently foresee paying upwards of 38% taxes on net income created by their rental portfolio.
Net Investment Income Tax: This is an added 3.8% tax that applies to anyone whose adjusted gross income for the year tops $200,000 (or $250,000 for those who are married and filing jointly). The 3.8% tax is on all passive investment income, which includes rental income.
As aforementioned, there are various write-offs, like depreciation, which can lessen your tax burden. Deductible expenses comprise of but are not limited to: advertising, local property taxes, repairs and maintenance, commissions, cleaning and maintenance, homeowners’ association dues or condo fees, depreciation, snow removal, pest control, insurance premiums, interest expenses, landscaping, management fees, supplies, trash removal fees, travel, and utilities.
Anything you subtract must be “ordinary and necessary,” according to the IRS. For example, travel needs to be directly associated with the property. If you’re commingling business with pleasure, you must designate the travel costs between deducible business expenses and nondeductible personal expenses. Still is always better to have a separate entity and the corresponding account to operate out of. Excellent record-keeping, especially with software, is the most reliable way to defend yourself in the event of an audit.
An individual who is a passive real estate investor is limited to taking $25,000 in write-offs each year. In theory, even a profitable rental property can generate “paper losses,” which can later be used against other passive income – such as dividends received on a stock portfolio. If you have more passive losses than passive income in a given year, you can “carry” those passive losses and roll them forward to the next tax year.
There’s another designation, called an “Active Investor,” which expands the deduction threshold from $25,000 to $50,000 for those who qualify. It is relatively straightforward to become qualified as an Active Investor. It would be best if you were involved in the decision-making process. For example, if you’re a limited (silent) partner that’s bought into a real estate fund, you’re most surely a passive investor. If you’re privately and wholly invested in two or three rental properties, you are an active investor. There is no burden of proof required to show the IRS that you are an active investor; obtaining this designation supremely easy for those who otherwise qualify.
Of course, this benefit doesn’t last forever. Regardless of whether you’re a passive or active investor, your eligibility to take these deductions begins to diminish once you make more than $100,000 in adjusted gross income. A single person who makes more than $150,000 in adjusted gross income cannot declare any write-offs against their passive income.
Rental Income is Taxed Differently if You’re a “Real Estate Professional”
In extension to Passive and Active Investors, the IRS has a third designation for “Real Estate Professionals.” Rental income is taxed very conversely when you’re a Real Estate Professional.
Let us elaborate.
Anyone who is a Real Estate Professional can write off 100% of their real estate losses (real or paper) on their ordinary income (not just passive income, as is the case with the other classifications). There is no ceiling on the value of the deductions you take. Therefore, Real Estate Professionals, especially those with large rental portfolios, can counterbalance their whole income (active and passive) via deductions, thereby showing zero tax liability at the end of each year.
Even if you can’t offset all of your income, you can unquestionably offset a big piece of it by employing this designation.
For example, let’s say you make $300,000 a year as a surgeon. Your rental portfolio produces $50,000 in losses each year via depreciation, expenses, and other deductions. Your spouse takes over the responsibility of handling your rental portfolio and is therefore eligible for Real Estate Professional status. The $50,000 can then be used to offset your earnings as a surgeon, thereby reducing your modified adjusted gross income to $250,000. This scenario saves you approximately $14,000 in taxes that year!
CONCLUSION
Are you intrigued? Thinking about becoming a real estate professional? We don’t blame you! Now we’ll need to address how to go about acquiring this coveted designation. Stay tuned for Part 2 of this series; then, we’ll investigate precisely how to go about becoming a qualified real estate professional. None of the above constitutes tax advice. Please confer with your Certified Public Accountant and/or Real Estate attorney for more definitive solutions.