If you own property that you rent out, there are some things you need to know. In addition to the potential for a steady income and capital growth, rental properties offer deductions that can reduce your income tax. However, you must first think about what type of investor you are. Are you passive or a professional? Your classification will determine how your income and losses will be treated.
Tax Treatment of Income & Losses
Real estate investing is a fairly passive activity. That being said, your participation will determine how income and losses are treated on your taxes.
Real Estate Professionals
According to the IRS, a real estate professional is one that spends more than 50% of their working hours in the rental business. Additionally, anyone that devotes more than 750 hours per year working on your rental property qualifies as a professional. The activity of real estate professionals is not passive. Instead, the income is active, which means you can use losses to offset other income, avoiding the 3.8% net investment tax if income is generated.
Material Participation
If you were materially participating as a real estate professional, your involvement will be considered non-passive. You can use losses to offset other income and won’t be subject to the net investment tax.
Active Participation
This type of participation is a lower standard than material participation. According to the IRS, you are actively participating if you made management decisions about the property.
Passive Participation
On the other hand, if your rental property is a sideline and you don’t participate in the investment, it’s considered passive. Passive losses can be used to offset passive income. In other words, you can’t use losses from the rental property to shelter other taxable income.
Rental Property Income Sources
If you own rental property, you must report all income- not just the monthly rent checks you receive. This includes:
Rent
Tenant-paid expenses
Trade for services
Security deposits
Rental Property Tax Deductions
If you own rental properties, it’s important to understand you can deduct a variety of expenses related to purchasing, maintaining, and operating your property. Here are a few of the most common deductions:
Mortgage interest deduction
Rental property depreciation
Repairs/Improvements
Property taxes
Travel expenses
Other common expenses
Advertising
Employees/independent contractors
Home office expenses
Lawn care
Insurance premium
Losses from natural disasters or theft
Professional services
Cost of personal property used in rental properties
Condos & Co-Ops
If you own a condo or co-op, there are some special considerations you must keep in mind.
Condo
If you own a condo, you are probably paying dues/assessments to maintain common areas. When you rent your condo, you can deduct expenses such as taxes, interest, repairs, and depreciation for common areas. On the other hand, you are not able to deduct capital improvements- but you can depreciate your portion of the cost.
Co-Op
If you own a co-op and are renting it out, the expenses are deductible. This includes fees for maintenance, paid to the HOA. Capital improvements are different. The costs cannot be deducted and they cannot be depreciated. Instead, they must be added to your cost basis in the stock, which reduces your capital gain when you sell.
Conclusion
If you own rental properties, you should be aware that it is most likely to be profitable when you think about the tax rules before you jump in. Since there are lots of deductions available, it’s important to know what you qualify for. Contact Ideal Financial Group to learn more.