The scenario is as follows: Let’s say you’re moving from your current home. Maybe it’s because of the miniaturization, or maybe it’s a place with good weather. Given that real estate looks like a pretty good inflation hedge, you may be reluctant to sell your immediate home. Moreover, according to recent estimates, Rent hit a record high, The median rent across the country has risen 14.1% year-on-year. Wow.
So should you turn your place into a revenue-generating rental property instead of selling it? perhaps. The pluses and minuses of federal income tax to consider are:
Items that can be depreciated to rental properties
You can deduct interest on mortgages and property taxes on rental properties.
You can also cancel all standard operating costs associated with owning a rental property (utilities, insurance, repair and maintenance, garden care, membership fees, etc.).
Finally, the tax base for residential buildings (not land) can also be depreciated over 27.5 years using the straight-line method, even if the value continues to rise (as desired). .. The initial tax base for real estate for depreciation purposes is usually the original purchase price minus the purchase price that can be allocated to the land, minus the improvement costs, minus the depreciation costs billed over many years. Equal to (for example, because there are depreciable items) in your home office).
Depreciation deductions are good because they can protect some or all of your cash flow from federal income tax. For example, let’s say your property (not including land) is based on $ 500,000. Annual depreciation is $ 18,182 ($ 500,000 / 27.5). Basically, you can get positive rental cash flow for the year without paying anything to Uncle Sam. good.
But … Passive loss rules can suspend rental tax losses
Things can get complicated when your rental property throws away tax losses. Horrible Passive Activity Loss (PAL) rules usually apply. In general, PAL rules allow you to deduct passive rental losses only if you have passive income from other sources, such as positive income from other rental properties or profits from their sale. Passive losses that exceed passive income are suspended until passive income increases or the lossy asset is sold.
Conclusion: PAL rules may defer loss deductions for rental properties, and in some cases may postpone them for years. Fortunately, there are exceptions to the PAL rule, which allows you to deduct losses faster rather than later. See the sidebar below.
What if I have positive taxable income from my rent?
Sooner or later, the rise in rent will exceed your deductible costs, so your rental property will probably throw away your positive taxable income. In today’s rental market, taxable income can be positive on the first day. Of course, you have to pay income tax on your rental income. However, if you have accumulated previously suspended passive losses, you can now use them to offset your passive gains.
Another caveat: Positive passive income from rental properties can suffer from a 3.8% net investment income tax (NIIT), and the profits from the sale of rental properties can also be hit by NIIT. However, NIIT only hits high-income earners. Please consult your tax accountant for more information.
Taxpayer-friendly rules at the time of sale
I hope you will eventually sell your converted property for a decent profit. In that case, after adding the improvement cost and deducting the depreciation cost including the depreciation charged after converting the asset to rent, the tax profit is obtained within the range where the net sale price exceeds the taxable standard of the asset. increase.
But … gain exclusion transactions may still be available
If you sell the former Main residence Within three years of converting it to a rent, a federal home sales profit-exclusion break will usually be available. Under that transaction, you can protect up to $ 250,000 in other taxable profits, or up to $ 500,000 if you are married. However, we cannot protect the profits resulting from depreciation, including the depreciation charged after converting the property to rent.
Tax results that do not exclude profits
If you sell a rental property that you have owned for more than a year and the profit exclusion transaction is not available because the rental period is too long, you will be charged the taxable profit (the difference between the net sales and the tax base) during the rental period. Assets after depreciation are usually treated as long-term capital gains. Therefore, under today’s rules, the federal tax rate is 20% or less, or 23.8% if you rent a 3.8% NIIT. However, some of the profits (the amount equal to the accumulated depreciation charged to the property) will be subject to a federal interest rate of 25% or 28.8% if you are borrowing 3.8% NIIT. The remaining profits are taxed at a maximum federal tax rate of 20% (or 23.8%) or less. Also keep in mind that you are obliged to pay state and local income taxes on the profits of your property.
Key Point: When evaluating the conversion of a highly valued home to a rental property, keep in mind that you will eventually lose one of the most valuable tax deductions in the book, the Exemption Privilege. .. Giving it up should not be underestimated.
Key Point: Remember the suspended passive loss we talked about earlier? You can use them to protect your taxable profits from selling highly valued rental properties.
Section 1031 exchange can postpone tax hits from sale
Federal Income Tax Act allows owners of rental property to withdraw a valued property while deferring the federal income blow indefinitely. Here we will talk about the exchange of section 1031 (named after the relevant section of our beloved Internal Revenue Code).
The 1031 exchange exchanges the property to be unloaded with another property (replacement property). You can defer tax payments until you sell the replacement property. Alternatively, when you are ready to drop the replacement property, you can arrange another 1031 replacement to continue the tax deferral.
You cannot monetize your real estate investment by making a 1031 exchange, but you can exchange your holdings in one area for real estate in a more promising location. In fact, the 1031 exchange rule gives you a great deal of flexibility when choosing alternative properties. For example, you can replace an expensive single-family rental home with a small apartment building, interest in a strip shopping center, or even raw land.
Click here for more information on Section 1031 replacement. Recent Tax Guy column..
Converting a private residence into a rental property can cause some potentially tricky tax laws. But if the location is throwing away positive cash flow and valuing it, it’s just the cost of doing business.
Sidebar: Three Favorable Exceptions to PAL Rules
Exception 1: For owners of “active” rental properties
This is the most widely available exception. It states that you can deduct up to $ 25,000 in rental property PAL if: (1) Adjusted Total Income (MAGI) is $ 100,000 or less, (2) Actively participate In the property. Active participation means at least making property management decisions such as tenant approval, rental contract signing, and repair approval. You don’t have to mow the lawn or meander the drains to pass the active participation test.
If MAGI is between $ 100,000 and $ 150,000, the exception will be phased out in proportion. For example, let’s say MAGI is $ 125,000. You can deduct up to $ 12,500 in PAL from actively participating rentals (half of up to $ 25,000). If your MAGI is greater than $ 150,000, you will not be subject to active participation exceptions.
Exception 2: For “real estate professionals”
This exception is only available to those we call real estate professionals. To qualify, you must spend at least 750 hours per year on real estate activities, including non-rental activities such as acting as a real estate agent or real estate broker. Substantially participate.. In addition, the time you spend on real estate activities that you effectively participate in must exceed 50% of the time you spend on personal service activities. Clearing these hurdles will exempt you from the loss from the rental property you are effectively participating in from the PAL rules and usually deduct the loss for the year in which it occurred.
Meeting material participation criteria is more difficult than passing the No. 1 active participation test. Here are three simplest ways to meet the material participation criteria for a rental property:
1. Make sure that the time spent on a property in a year constitutes virtually all the time spent by all individuals (including non-owners).
2. Spend more than 100 hours on the property and make sure no other individual is spending more time than you.
3. Spend more than 500 hours on the property.
Exception 3: For short-term rentals
Let’s say you decide to rent a property in the short term through Airbnb or VRBO. If the average rental period of the property is less than 7 days, you can bypass the PAL rule by effectively participating in the property, as explained just before. After that, you can usually deduct the rental loss from the property in the year in which it occurred.