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. One of the biggest benefits of owning rental property is that the tenants, over time, buy the property for you. In addition, if structured properly, the allowable depreciation deduction will shelter the rental income. Another historical benefit of real estate rentals is capital appreciation. Before acquiring a rental property, consider the following: After-tax cash flow, Potential for long- or short-term appreciation, Property condition (with an eye on when you might get stuck with a large repair bill), Debt reduction, Type of tenants, Potential for rent increases or re-zoning, and Whether there is community rent control, etc. Although most of the considerations are subjective, the after-tax cash flow can be estimated fairly easily. Operating ExpensesFor tax purposes, you will figure your profit or loss each year from operating the rental property. Generally, you can deduct all expenses incurred to operate the rental. The following are potential operating expenses that are deductible: Advertising Cleaning & maintenance Bank charges – if a separate account is maintained. Insurance – fire, casualty and liability Utilities – gas, electricity, water, cable, etc. Services – yard care, pool service, pest control, etc. Rental commissions Property management fees Mortgage interest – on debt to acquire or improve the rental. Property taxes Repairs – see repairs vs. improvements below. Local transportation expenses Homeowners’ or association dues Tax return preparation fees Depreciation allowance – see depreciation below. Repairs Vs. ImprovementsWhen figuring 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? Repairs – A repair keeps your property in good operating condition and does not materially add to the value of your property or substantially prolong its life. Improvements – An improvement will add to the value of the property, prolong its useful life, or adapt it to new uses. If you make an improvement to a property, the cost of the improvement must be capitalized. Safe Harbor Election – IRS regulations permits a taxpayer with $10 million or less in average annual gross receipts in the three preceding years, and whose building has an unadjusted basis of $1 million or less, to make an irrevocable election to immediately deduct rather than depreciate improvements. To qualify, the total amount paid during the year for repairs, maintenance, improvements and similar activities made to the building may not exceed the lesser of 2% of the building’s unadjusted basis or $10,000. The election is made on a building-by-building basis and generally can only be made on an original return. Special rules apply if the taxpayer leases rather than owns the building. 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. 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. Passive Loss LimitationsAs an investment (not a business), rental real estate income is not subject to Social Security taxes. However, as with business activities, real estate rentals are considered passive activities. Generally, passive activity losses are only deductible to the extent of passive activity income. However, there are two exceptions to that rule: (1) 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. You actively participate in the rental activity if you make key management decisions or arrange for others to provide services. Active participation does not require regular, continuous and substantial involvement with the property. But in order to satisfy the active participation test, you (together with your spouse) must own at least 10% of the rental property. Ownership as a limited partner does not count. If your adjusted gross income (AGI) is above $100,000, the $25,000 allowance amount is reduced by one-half the excess over $100,000. (If you’re married, file separately and are eligible for the break, the $12,500 allowance amount is reduced by one-half the excess over $50,000.) Under this rule, if the AGI is $150,000 or more ($75,000 or more for eligible married taxpayers who file separately), the allowance is reduced to zero. For these purposes, AGI is modified to some extent, e.g., you ignore taxable Social Security income and the Individual Retirement Account (IRA) deduction. (2) Real Estate Professional Exception – 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. Any losses not allowed under these two exceptions are not lost but suspended, and carried forward indefinitely to tax years in which your passive activities generate enough income to absorb the losses. Spcial SituationsThere are a number of special circumstances involving the rental of real estate. 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. 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. Renting Part of Property – If you rent part of your property, you must divide certain expenses between the part used for rental purposes and the part 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 other expenses that are normally nondeductible personal expenses, such as utilities and home repairs. You do not have to divide the expenses that belong only to the rental part of your property. Generally, the most frequently-used methods of allocating expenses between personal and rental use are: (1) based on the number of rooms in the home, and (2) based on the square footage of the home. You can use any reasonable method for dividing the expense. 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. Renting to a Relative – When a taxpayer rents a home to a relative for long-term use as a principal residence, the tax treatment of the rental depends upon whether the property is rented at fair rental value or rented at less than the fair rental value. A fair rental is determined based upon facts and circumstances and by taking into account such factors as comparable rentals in the area. Rented at Fair Rental Value – Where the home is rented to the relative at a fair rental value, it is treated as an ordinary rental reported on Schedule E, and losses are allowed subject to the normal passive loss limitations. Rented at Less Than Fair Rental Value – When a home is rented at less than the fair rental value, it is treated as being used personally by the taxpayer, and so the taxpayer would have to allocate the expenses between the personal and rental portions of the year. However, since all the rental days (at a bargain rate to a relative) are treated as personal days, the rental portion is zero. So none of the expenses are deductible, other than property taxes and mortgage interest, assuming the interest would otherwise qualify as second home mortgage interest and the taxpayer itemizes deductions. The rent received would be then fully included in income. 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. When determining the personal-use days, do not include days when you are performing repairs or fixing up the property.