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RENTAL REAL ESTATE AS AN INVESTMENT


A popular form of long-term investment is real estate rentals.  Rentals can fall into several varieties, of which real estate rentals is the most common.  This material will explain some of the tax ramifications of renting real estate, both residential and commercial.  Specifically excluded from this discussion are transient rentals, where the tenants rent for an average of seven days or less, such as motels and equipment (machinery) rentals.  Both are considered self-employment businesses for tax purposes and thus subject to self-employment taxes.
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Active Participation


If you “actively participate” in the residential rental activity, you may be able to deduct a loss of up to $25,000 ($12,500 if you’re married, file separately, and live apart from your spouse for the entire year—but if you’re married, file separately and don’t live apart from your spouse for the entire year, you’re not eligible for this break at all) against ordinary (nonpassive) income such as your wages or investment income.
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Depreciating Rental Property


“Depreciation” is an accounting term for writing off the wear and tear on an asset that has a useful life of more than one year and costs over $100. Generally, rental real estate improvements must be depreciated over a period of 39 years. However, there are exceptions for residential rental real estate, which is depreciated over 27.5 years and most personal property such as furniture, equipment, etc., which is depreciable over 5 or 7 years. There are additional special rules applying to land rentals, leasehold improvements and restaurants. Please call this office for special situations.

First, Last and Security Deposits


Generally, landlords require a new tenant to pay the first and last month’s rent in advance along with a security deposit. A frequent question is whether to treat these payments as current-year income or income to a future year. The IRS says that advance rent payments are income in the year received. However, security deposits you plan to return to your tenant at the end of the lease are not income. But if you keep part or all of the security deposit during any year because your tenant does not live up to the terms of the lease, then the amount kept is income for that year.

Operating Expenses


For tax purposes, you will figure your profit or loss each year from operating the rental property. Generally, you can virtually deduct all expenses incurred to operate the rental.
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Outright Sale


When a rental property is sold outright, the entire gain will be taxable in the year of sale. Let’s assume (without considering property improvements or buying or selling costs) that you purchase a rental for $50,000 and then several years later sell it for $300,000. Over the period of time that it was a rental, you took $10,000 in depreciation deductions. Your tax basis in the property at the time of sale would be $40,000 (your cost of $50,000 less the $10,000 taken in depreciation). Thus, your gain would be $260,000 (the sales price of $300,000 less your tax basis of $40,000). The recaptured depreciation of $10,000 can be taxed as high as 25%, depending on your tax bracket and the balance of the gain ($220,000) is taxed at a maximum of 15%.

Real Estate Professional


If you qualify as a “real estate professional” (which requires the performance of substantial services in real property trades or businesses), your rental real estate activities are not automatically treated as passive, and so losses from those activities can be deducted against earned income, interest, dividends, etc., if you materially participate in the activities. Please call this office for additional details associated with this limited exception.

Renting Part of Property


If you rent part of your property, such as a room or a portion of the house, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property. You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest and real estate taxes, as rental expenses. You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as utilities and home repairs (such as painting the outside of your house). You do not have to divide the expenses that belong only to the rental part of your property.
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Renting to a Relative


Special rules may apply when renting a home or apartment to a relative. If you rent a home to a relative who: (1) uses it as his or her principal residence (that is, not just as a second or vacation home) for the year, and (2) it is rented at a fair rental (not at a discount), then no limitations apply. You simply treat it like any other rental property. However, if it is rented to a relative at below fair rental value, all of the expenses, except mortgage interest and property taxes, are considered personal expenses and therefore not deductible. Thus, it is important to set a “fair” rental rate when renting to a relative. Factors to look at include comparable rentals in the area and whether “side” gifts were made by you to your relative, which could be reasonably interpreted to be the bargain element. Relatives for this purpose include your spouse, child or grandchild, parent or grandparent, and siblings.

Repairs vs. Improvements


When you figure your profit or loss from operating the rental property each year, you can deduct the cost of repairs to the rental property. However, any improvements that were made must be depreciated over the improvement’s useful life. How do you distinguish a repair from an improvement?
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Separating Improvements from Land


Not all of the cost of acquiring real estate is depreciable. Specifically, the cost of the land is not depreciable and must be separated from the improvements. Thus, you should identify and document at the time that you acquire real estate, the part of your overall acquisition cost allocable to improvements. One way to accomplish this is to retain a qualified real estate appraiser to make an allocation between land and improvements, or if the real property tax bill for the property includes an allocation, and most do, use that allocation. When using the property tax, the total of the allocation between the land and improvements probably will not equal the actual purchase price. In that case, simply allocate the land and improvements in the same proportion as the property tax bill. Any improvements made after the original purchase should be accounted for and depreciated separately, since there is no land allocation associated with the improvement.

Tax-Deferred Exchange


A tax-deferred exchange (otherwise known as a “1031 exchange” referring to the tax code section pertaining to exchanges of property or “tax-free exchange” and a misleading title since the tax is actually deferred and not free“) can be used as a means of avoiding immediate taxation on the gain from a rental property by deferring the gain into a replacement property.
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Vacation Home Rental


There are special tax consequences when you rent out your vacation home for part of the year. The tax treatment depends on how many days it is rented and your level of personal use. Personal use includes vacation use by your relatives (even if you charge them market rate rent) and use by non-relatives if a market rate rent is not charged.
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