Posted November 11, 2017
Rental properties can be great investments and offer ways to shelter your taxable income. However, there are several tax related issues during the purchase, management and sale of your rental property. The proper handling, coordination and reporting of taxable events such as closing costs, repairs versus improvements, depreciation, 1031 exchanges (and even reverse 1031 exchanges) seemingly innocent HOA dues and mileage can improve your tax consequence. While incorrect tax reporting can start the slow brewing of future problems.
Please see our Rental Property FAQs to review several tax issues including rental deductions and rental depreciation.
Rental Property Business Owners
Most rental property owners would define themselves as investors. Yeah, Sure, why not? However, would you call Warren Buffett an investor or a business owner? We would call him a business owner who happens to make investments with his business into other businesses. Perhaps we are splitting hairs and getting caught up in semantics, but at the same time we look at you and your rental properties as a business. As such, your business needs the care and guidance of business consultants and that’s where the Watson CPA Group excels. We help you take the emotions out of rental property management and have a detached, business-oriented perspective to help you build wealth.
AirBNB and VRBO Rental Property
Being in Colorado we see a ton of short-term rental activity on ski condos. Service providers such as AirBNB, VRBO and HomeAway are making renting your home a snap. How is this handled? There are rules about personal use of a rental and loss limits. Expenses must be pro-rated. Deductions such as property taxes and mortgage interest are allocated.
How about your main home? Jason and Tina Watson rent out their primary residence for Air Force Graduation and Parents’ Weekend. It takes some patience, some planning and some help. Since they rent out their home for 14 days or less, they don’t pay any income taxes (otherwise known as the Masters’ rule). Hey, don’t hate the player… hate the game. No taxes sounds like a great game. Make your tenants pay for your next vacation… tax free!
One of the most frequent questions from taxpayers is regarding rental property depreciation. Should you do it or no? Well, the IRS says it doesn’t matter because of a little rule called allowed versus allowable. This little nugget basically says if depreciation was allowable then it is considered taken (deducted). In other words, even if you do not depreciate the rental property the IRS will assume you did. Yuck. What can be done if you haven’t deducted rental property depreciation in the past? We can usually true up under a Section 481(a) adjustment or the more complicated Form 3115 (Change in Accounting Methods). Either way, we can help.
Do you depreciate your short-term rental? Perhaps.
Repairs Versus Improvements
Here are some common questions about rental property repairs and improvements.
- I painted the inside and out. Do I depreciate that?
- I put carpet in the whole place. Do I expense that? I put carpet in just one room. Now what?
- I replaced a water heater. How does that work?
- I fly to Tahoe every winter to ski and look at possible condos to buy. Can I deduct my travel expenses?
- I drove back and forth to Home Depot a zillion times for a kitchen reno. Can I deduct mileage?
- I bought four dishwashers for my quadplex. Can I expense them or must I depreciate them? (spoiler alert- you can immediately expense under safe harbor rules).
Deducting expenses and capitalizing improvements must be handled properly. Let us help! For now, read our Repairs Versus Improvements KB article.
Rental properties are lousy tax vehicles for two really big reasons. First, if you make too much money (adjusted gross income over $100,000 for married taxpayers), then your rental losses are slowly capped from $25,000 at $100,000 to $0 at $150,000. In other words, if your rental loses $20,000 but your income is $150,000, your deducted is zippo. Those losses do carry forward to future years however. There are exceptions for Real Estate Professionals as defined by the IRS.
Second, and this is a bite you in the butt thing… most rental losses are created by depreciation. However, when you sell the property you must add back depreciation into your gains calculations. This little surprise is known as depreciation recapture. Therefore your deductions all these years was truly an IOU to the IRS upon sale, unless you perform a 1031 like-kind exchange (you can also do a reverse 1031 which is where you buy the next property first and then less the relinquished property- tricky, but we can guide you).
So why do people want to own a whole gaggle of rental properties if they stink at lowering your tax burden. Simple. Rental properties build wealth, and at the end of the day, wealth building is what your primary objective should be. If you can save some taxes along the way, then winner winner chicken dinner. But the prize is truly wealth building.
Rental Property Consultants
The principals at the Watson CPA Group have been rental property owners since 1996, and can offer comprehensive tax advice coupled with real-life rental property business consultation. Whether you have one rental or several, single family or multi-unit, own them personally, in a self directed IRA or in an LLC with your partners, we have the practical experience to accurately prepare your rental property tax returns. More importantly, we have the expertise to help you plan for the future!
Other questions come up, such as moving back into your rental. How do you handle rental depreciation recapture? Should I put my rentals into an LLC? What about Hold Harmless Agreements with my tenants? How is the current gain on personal residence sale of $250,000 and $500,000 handled with part years being a rental? Common questions- but each answer must be customized to your unique situation.
Considering a Section 1031 exchange to defer capital gains? Also known as like-kind exchanges. This can be a great plan, but needs guidance before, during and after. How about a reverse 1031 exchange? Yes! This is where you buy the replacement property prior to selling the relinquished property. This needs the help of an intermediary and a sharp attorney, but it is easily done in situations where a great deal comes along but your timing is all out of whack.
There are some tricks of trade for reducing capital gains and depreciation recapture like increasing land allocation upon sale to eat into some of the recaptured depreciation since land is not depreciated but goes up in value. Location location location. This gets tricky and might involve an appraisal (hopefully you can get a copy from your buyer).
What about a second home that you purchased for grandma? Do you call that a rental and have her pay you rent? Or is it better to call it a second home, and let grandma pay you in food and babysitting duties?
Again, these are all common scenarios and we help present various options including how to position yourself to maximize your wealth building.
Many tax preparation companies charge you a basic rate, and then add on additional charges for eFiling, joint returns, rental properties, capital gains, small businesses, etc. And once you’re committed and find out the total fee, it’s too late. We offer a fee range of $500 to $700 for most rental property owners including our August and November financial tune-ups (see below). Our fee also includes your rental depreciation schedules, state tax return and eFiling (no kidding… who charges for eFiling anymore?).
Your fee could increase depending on the number of rental properties. We have a handful of clients who have more than 30 rental properties, and those tax preparation fees are upwards to $2,000 to $2,500.
August and November Financial Tune-Ups
For those clients who have a tax-only engagement with us, we offer a lot more than just a tax return. Tax returns are boring. Tax planning including projections and end of year tax moves is way more valuable to you than 100 pages of gobbly-goo in some dust-catching PDF aimed at IRS compliance. Wow, that is a long sentence… anyways, in August we offer a tax planning tune-up and later on in November we offer an end of year tax consultation. These are complimentary consultations. Sure, you’re paying for it in some fashion with your tax preparation fees above but then again, this is a valuable service that most tax professionals don’t offer. Click the buttons below for more information. Riveting!
The Watson CPA Group are tax and business consultants, not just number crunchers. And owning and operating a rental property is a business, and should be viewed as such. Anyone can balance a checkbook. Anyone can put the right number in the right blanks. But we take a consultative approach to your rental property tax preparation. You can always find someone to do it for less- of course. However consider the solid back-end support that you will get with the Watson CPA Group which other tax preparation companies might not provide. Read more about our Value Proposition here.
To be a real estate professional, an individual must spend the majority of his or her time in real property businesses which include development or redevelopment, construction or reconstruction, acquisition or conversion, rental, management or operation, leasing and / or brokerage.
In addition, more than half of the personal services performed in all businesses during the year must be performed in real estate businesses. So, if you have garden variety W2 job working 2000 hours a year, you need to spend 2001 hours in real estate activities. Wait! There’s more. Second, your hours worked in the real estate activity must be more than 750 hours. Steep thresholds.
If you own multiple rental properties each will be considered a separate entity and you must satisfy the above requirements on each property independently unless an election is made to treat all those interests as a single activity. This election is simply a statement that is attached to your tax return. And under Revenue Procedure 2010-13, you can make the election retroactively (typically requires amending a tax return just for the election).
Once you qualify as a real estate professional, you must materially participate in the operation of your rental property business. This is where it gets tricky, and this is where most rental property owners get into trouble. If you cannot prove material participation in your rental activities, you will be subjected to passive loss limitations (currently $25,000).
Realtors and agents beware! Just because you spend 3,000 hours hauling around buyers doesn’t mean you are a slam dunk for the real estate professional designation. Real estate agent DOES NOT automatically qualify you. The material participation rules must be met, and the 750 hours dedicated to your rental activity is outside your work as a real estate agent, realtor, broker, etc.
For more information directly related to the IRS definition of real estate professional and the tests for material participation please click on the button for a series of KnowledgeBase articles including tax court cases-
This is a hot topic for the IRS so stay out of trouble.. give us a call!
Rental properties can offer excellent retirement and cash flow options, but the tax planning needs to be done ahead of time and not later. We look forward to working with you!
The Watson CPA Group (team profile)