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How to work the tax angles if you become a landlord

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How to work the tax angles if you become a landlord

By Bill Bischoff

Published: Oct 7, 2019 6:03 a.m. ET


Converting your personal residence into a rental can make for a complex tax situation



You might be thinking about buying a new residence and converting your existing place into a rental property that you can sell later for a higher price. Beware of tax implications.
Residential real estate prices are climbing in many areas, and rental rates are strong. To take advantage of this favorable situation, you might be thinking about buying a new residence and converting your existing place into a rental property that you can sell later for a higher price. Good idea!

Of course, converting a personal residence into a rental has important tax implications. Here’s Part 2 of what you need to know. For Part 1, see here.
Landlord tax rules in a nutshell

Once you’ve converted a former personal residence into a rental, you must follow the tax rules for landlords. What fun! Here is a quick-and-dirty summary of the most important things to know.
What you can write off

You can deduct mortgage interest and real estate taxes on a rental property.

You can also write off all the standard operating expenses that go along with owning a rental property: utilities, insurance, repairs and maintenance, yard care, association fees, and so forth.

Finally, you can also depreciate the tax basis of a residential building over 27.5 years, even while it is (you hope) increasing in value. Say the basis of your rental property (not including the land), as determined under the rules explained here, is $400,000. Your annual depreciation deduction is $14,505, which means you can have that much in positive cash flow without owing any income taxes. Nice!

But beware of dreaded passive loss rules

If your rental property throws off a tax loss, things can get complicated. The so-called passive activity loss (PAL) rules will usually apply. In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources--like positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have more passive income or you sell the property or properties that produced the losses.

Bottom line: the PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, there are exceptions to the PAL rules that can allow you to deduct losses sooner rather than later.
What if you have positive taxable income from your rental?

Eventually your rental property should start throwing off positive taxable income instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you now get to use them to offset your passive profits.

Another nice thing: positive taxable income from rental real estate is not hit with the dreaded self-employment (SE) tax, which applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3%, so it’s a wonderful thing when you don’t have to pay it.

One bad thing: positive passive income from rental real estate can get socked with the 3.8% net investment income tax (NIIT) and gains from selling properties can also get hit. However, the NIIT only hits upper-income folks. Consult your tax adviser for details.
Taxpayer-friendly rules when you sell

Assuming the current federal income tax regime (or something close to it) is still in place when you sell your rental property, favorable rules apply.
Gain exclusion deal may be available

If you sell your former principal residence within three years after converting it into a rental, the federal home sale gain exclusion break will usually be available. Under that break, you can shelter up to $250,000 of otherwise-taxable gain or up to $500,000 if you are married. However, you cannot shelter gain attributable to depreciation, including depreciation claimed after you convert the property to a rental.
Results with not gain exclusion

When you sell a rental property that you’ve owned for more than one year and the gain exclusion deal is unavailable, the tax gain (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions during the rental period) is generally treated as a long-term capital gain. As such, it is taxed under the current rules at a federal rate of no more than 20%, or 23.8% if you owe the 3.8% net investment income tax (NIIT).

However, part of the gain — an amount equal to the cumulative depreciation deductions claimed for the property — is subject to a 25% maximum federal rate, or 28.8% if you owe the 3.8% NIIT.

The rest of your gain will be taxed at a maximum federal rate of no more than 20% (or 23.8%). Don’t forget that you may also owe state and local income taxes on real estate gains.

It’s important to remember that property appreciation is not taxed until you actually sell. Good properties can generate the kind of compound tax-deferred growth that investors dream about. You can even pocket part of your appreciation in advance by taking out a second mortgage against the property or by refinancing with a bigger first mortgage. Such cash-out deals are tax-free.

Key point: Remember those suspended passive losses we talked about earlier? You can use them to shelter otherwise-taxable gains from selling an appreciated rental property.
Section 1031 exchange can defer tax hit from selling

The tax law allows rental real estate owners to unload appreciated properties while deferring the federal income hit indefinitely. Here we are talking about Section 1031 exchanges (named after the applicable section of our beloved Internal Revenue Code).

With a 1031 exchange, you swap the property you want to unload for another property (the so-called replacement property). You’re allowed to put off paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange yet another 1031 exchange and continue deferring taxes.

While you cannot cash in your real estate investments by making 1031 exchanges, you can trade holdings in one area for properties in more-promising locations. In fact, the 1031 exchange rules give you tons of flexibility when selecting replacement properties. For example, you could swap an expensive single-family rental house for small apartment building, an interest in a strip shopping center, or even raw land.
The bottom line

All things considered, the tax rules after you become a landlord are pretty favorable. But they are complicated. Consider seeking professional advice before making a final decision on a conversion.
Three favorable exceptions to the PAL rules

Exception No. 1: for “active” investors

The most widely-available exception says you can deduct up to $25,000 of rental property PALs if: (1) your modified adjusted gross income (MAGI) is no more than $100,000 and (2) you actively participate in the property. Active participation means at least making property management decisions like approving tenants, signing leases, authorizing repairs, and so forth. You don’t have to mow lawns or snake out drains to pass the active participation test.

If your MAGI is between $100,000 and $150,000, the exception is phased out pro-rata. For example, say your MAGI is $125,000. You can deduct up to $12,500 of PALs from rental properties in which you actively participate (half the $25,000 maximum). If your MAGI exceeds $150,000, you are completely ineligible for the active participation exception.

Exception No. 2: for real estate pros

This second exception is only available to folks we will call real estate professionals. To be eligible, you must spend over 750 hours during the year in real estate activities (including non-rental activities such as acting as a realtor or real estate broker) in which you materially participate. In addition, the hours you spend on real estate activities in which you materially participate must exceed 50% of all the time you spend working in personal service activities. If you clear these hurdles, losses from rental properties in which you materially participate are exempt from the PAL rules, and you can generally deduct them in the year they are incurred.

Meeting the material participation standard is harder than passing the Exception No. 1 active participation test. The three easiest ways to meet the material participation standard for a rental property are by:

1. Making sure the time you spend on the property during the year constitutes substantially all the time spent by all individuals (including non-owners).

2. Spending more than 100 hours on the property and making sure no other individual spends more time than you.

3. Spending over than 500 hours on the property.

Exception No. 3: For short-term rentals

Say you rent out your property on a short-term basis through Airbnb or VRBO. If the average rental period for your property is seven days or less, you can avoid the PAL rules by materially participating in the property, as explained immediately above. Then you can generally deduct rental losses from the property in the year they are incurred.


https://www.marketwatch.com/story/h...ecome-a-landlord-2019-10-07?mod=mw_latestnews
 

EO 11110

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can/should also depreciate furnishings - like washer/dryer.....other appliances....furniture...etc. the depreciation schedule for those is much faster. i think 7 years?
 

edsl48

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This just is a small example of how complex the tax code has become.
Incidentally EO I have been using 5 years on my appliances in my units. I can't say you are wrong and can't say I'm wrong...what a mess.

Years ago some magazine would have a tax problem handed out to professionals and found that they each came up with a different tax liability for the same set of facts.

Some years later one IRS District did the same experiment with its Agents handing out a problem and then finding out each Agent had a different answer for the same set of facts. The tax code has become ruined with assorted pitfalls, traps and rewards often based upon assorted special interest lobbying groups. It just goes to show how the Government can not be relied upon to do anything that truly benefits the people. Taxes at the moment don't even bear any relationship with the debt as the spending is not lawfully aligned to tax collections. A true total mess brought to us all each and every election by the public of the United States.
 

nickndfl

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FYI, the best rental income comes from small oceanfront short term rental units of 3-7 days. Charge a higher rate and generate more turnover, but < 3 nights incurs higher expenses.
 

EO 11110

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FYI, the best rental income comes from small oceanfront short term rental units of 3-7 days. Charge a higher rate and generate more turnover, but < 3 nights incurs higher expenses.
been there done that. was one of the pioneers in the galveston, tx market. then the market got swamped with amateurs......so i bailed
 

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Beginning with tax years after 2017, the total amount of deductible state and local income taxes, including property taxes, is limited t $10,000 per year.
 

EO 11110

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Beginning with tax years after 2017, the total amount of deductible state and local income taxes, including property taxes, is limited t $10,000 per year.
greatest scam never told....until team orange man brought it into the light

cant believe they hid it so well for so long (the part that allowed dollar for dollar income tax deduction for state income tax)
 

edsl48

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Beginning with tax years after 2017, the total amount of deductible state and local income taxes, including property taxes, is limited t $10,000 per year.
However I am not sure that applies to rental property. Business types of deductions are a deduction
'for adjusted gross income" while non business deductions are a deduction "rom adjusted gross income" in computing taxable income; a very big difference assuming I still know a bit of my stuff after retiring.
 

nickndfl

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Anybody with an expensive house will max out. Ocean access in Florida will push the limits. The property taxes on my primary residence are < $4k, but I own lots of vacant land and 2 other rentals which puts me closer to $12-$15k.
 

edsl48

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Anybody with an expensive house will max out. Ocean access in Florida will push the limits. The property taxes on my primary residence are < $4k, but I own lots of vacant land and 2 other rentals which puts me closer to $12-$15k.
You will most probably report your property situations on a Schedule E...and there is no limit on taxes there. On your primary residence thats a new ball game.
 

EO 11110

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Anybody with an expensive house will max out. Ocean access in Florida will push the limits. The property taxes on my primary residence are < $4k, but I own lots of vacant land and 2 other rentals which puts me closer to $12-$15k.
of course you charge the land and rentals' taxes against your cost basis and rental revenue, right?

so are getting the full deduct on them
 

edsl48

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of course you charge the land and rentals' taxes against your cost basis and rental revenue, right?

so are getting the full deduct on them
Not sure if I understand your question (nothing new I dont understand a lot of things) regarding being charged to cost basis. Taxes on rental property are not limited by the limitations set on personal itemized deductions.

On the example shown above the individual is in the business, or actually an activity engaged in for profit or supplemental income activities, that is spelled out in Section 212 of the Internal Revenue Code. The big distinction between an IRC Section 212 activity vs operating a trade or business under section 162 et al is that 212 activities are not subject to social security taxes and as I am sure we can all see that is very big difference.

The profit or loss from a 212 activity gets added to your other sources of income to generate "Adjusted Gross Income." The tax deduction limitation only applies to the amounts deducted to arrive at one's taxable income.

Now in the case above I think just from what I see I would put the taxes on the vacant ground with the taxes on the rental property taking the position that the taxpayer is involved in an IRC Sec 212 activity and the land is a part of that activity. Now if there was no rental property involved I do believe the Service would hold that the land is a personal investment and as such would be subject to the personal provision limitations on real estate taxes.

Incidentally land does not depreciate for tax purposes. There are depletion deductions for the extraction of minerals and oil but heaven forbid lets no go there and here is what I am trying to point out.

Here is what Section 212 says:

In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—
(1)
for the production or collection of income;
(2)
for the management, conservation, or maintenance of property held for the production of income; or
(3)
in connection with the determination, collection, or refund of any tax.


Now as to taxes on your personal residence let's look at IRS topic 503:

There are four types of deductible nonbusiness taxes:

  • State, locaforl, and foreign income taxes
  • State and local general sales taxes
  • State and local real estate taxes, and
  • State and local personal property taxes


To be deductible, the tax must be imposed on you, and you must have paid it during your tax year. Nonbusiness taxes may only be claimed as an itemized deduction on Form 1040, Schedule A, Itemized Deductions (PDF).

Your deduction of state and local income, sales, and property taxes is limited to a combined total deduction of $10,000 ($5,000 if married filing separately).

So hopefully this makes it a bit clearer. Taxes on those engaged in rental property activities do not have their deduction for taxes limited by the $10,000. rule. Only non business personal taxes are affected by that limitation.


(Note: AT one time one could elect to capitalize Taxes and interest arising from investment property as a part of the basis. Assuming that someone is holding only vacant land as a speculation and is forced into claiming a deduction subject to the limitations mentioned above they may find this as a better option particularly when they are deducting their personal residence so that the limitation kicks in.


I grabbed this over at NOLO Law and maybe it makes it all clearer

Tax Deductions for Vacant Land
What tax deductions you're entitled to will depend on what type of land owner you are.
By Stephen Fishman, J.D.


You can’t add them to your property’s basis as described below.Vacant land has long been viewed by many as an attractive investment. After all, it's the stuff they're not making any more of. You usually earn no income from vacant land, but you do have expenses for such items as property tax, interest, and other carrying costs. Can you deduct these costs? It depends.

Are You a Real Estate Dealer?
First of all, for tax purposes there are two types of people who own vacant land: investors and real estate dealers. Real estate dealers are in the business of buying and selling land. A dealer buys property and resells it, usually at a price higher than the purchase price, and normally after only a short holding period. A good example is a subdivider who buys large tracts of vacant land, divides them into smaller lots, and then resells the lots piecemeal. Numerous and continuous sales over an extended time period are the hallmark of a real estate dealer.
Real estate dealers are entitled to the much the same deductions as any other business owner. They can deduct all the expenses of owning the vacant land they buy and sell, including interest, taxes, and other carrying costs. If you are a sole proprietor, these are deducted on IRS Schedule C.
On the down side, all the profits real estate dealers earn from their business are taxed at ordinary income rates instead of capital gains rates. Moreover, they must pay Social Security and Medicare taxes on their net self-employment income, as well as income tax. Also, real estate dealers are not allowed to take depreciation deductions. So if the land has structures on it, their cost cannot be deducted.
Are You a Real Estate Investor?
A person who purchases real estate as an investment is not in the business of buying and selling vacant land on a continuous and extended basis. Rather, he or she purchases land and usually holds on to it for some time in the hope that it will appreciate in value. Since an investor is not engaged in a business, he or she is not entitled to business deductions and does not file Schedule C.
However, many investment expenses are deductible as personal itemized deductions on Schedule A. These expenses are an ordinary tax deduction that results in tax benefits at your regular income tax rate, which can be as high as 37% in 2018 through 2025 (40.8% if you're subject to the new Medicare net investment income tax).
Interest
Any interest an investor pays on money borrowed to purchase vacant land is investment interest that can be deducted as an itemized personal deduction. However, the annual deduction for investment interest is limited to the investor's net investment income for the year. Any excess is carried over to future years. You determine the amount of your net investment income by subtracting your annual investment expenses (other than interest expenses) from your investment income.
Example: George purchases a vacant lot on which he pays annual property taxes of $1,000 and interest of $2,000. His only other investment is a savings account which earns $2,000 in annual interest. His net investment income is $1,000 ($2,000 interest income - $1,000 property tax expense = $1,000. Thus he may deduct only $1,000 of his interest expense. The excess $1,000 is carried over to future years.



Property Taxes
An investor can also deduct property taxes paid on a vacant land as a personal itemized deduction on Schedule A. This deduction is not limited to the amount of net investment income. Nor is it subject to the $10,000 annual limit on deducting property tax paid on a main or second home. The $10,000 limit, enacted for 2018 through 2025 by the Tax Cuts and Jobs Act (TCJA) does not apply to investment property.
Other Expenses Not Deductible
Until 2018, other carrying costs, such as legal and accounting fees, landscaping, insurance, and travel expenses, could be deducted as miscellaneous itemized deductions on Schedule A, but only to the extent the exceeded 2% of the taxpayer's adjusted gross income. However, the Tax Cuts and Jobs Act eliminates all such deductions by individual taxpayers during 2018 through 2025. And, you can’t add these expenses to your property’s basis as described below. Thus, these expenses have no tax benefit during 2018-2025.
If You Don’t Itemize
If you don't itemize your deductions on your tax return, you won't be able to deduct the property tax and interest expenses you incur from owning vacant land. In this event, you should elect to add these expenses to your land's cost basis. This will reduce any taxable profit you earn when you sell the property.
Example: Jean purchases a vacant lot for $10,000. Over the next four years she elects to add $5,000 in carrying costs to the lot's cost basis. At the end of that four years, her adjusted basis in the lot is $15,000. She sells the lot for $20,000. Her taxable gain is only $5,000 ($20,000 sales price - $15,000 adjusted basis = $5,000).
You must make an annual election to add these costs to your land's basis--"capitalize" them in tax jargon. You can elect to capitalize all your costs, or capitalize some and not others--for example, you could capitalize interest but not property taxes.
To make this election you should add a statement like the following to your tax return:
"For tax year _____, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes and mortgage interest on the 111 First St. vacant lot."
You need to make this election each year you want to add these costs to your land's basis. If you wish, you can make the election some years you own the property, and not make it in others.
https://www.nolo.com/legal-encyclopedia/tax-deductions-vacant-lands.html
 
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EO 11110

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that covered it! this, on recovering the property taxes:

If You Don’t Itemize
If you don't itemize your deductions on your tax return, you won't be able to deduct the property tax and interest expenses you incur from owning vacant land. In this event, you should elect to add these expenses to your land's cost basis. This will reduce any taxable profit you earn when you sell the property.
 

edsl48

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that covered it! this, on recovering the property taxes:

If You Don’t Itemize
If you don't itemize your deductions on your tax return, you won't be able to deduct the property tax and interest expenses you incur from owning vacant land. In this event, you should elect to add these expenses to your land's cost basis. This will reduce any taxable profit you earn when you sell the property.
Don't forget this part :
"To make this election you should add a statement like the following to your tax return:
"For tax year _____, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes and mortgage interest on the 111 First St. vacant lot."
 

nickndfl

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I also own a business for 5+ years and starting another one this month, so I itemize everything.
 

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This just is a small example of how complex the tax code has become.
Incidentally EO I have been using 5 years on my appliances in my units. I can't say you are wrong and can't say I'm wrong...what a mess.

Years ago some magazine would have a tax problem handed out to professionals and found that they each came up with a different tax liability for the same set of facts.

Some years later one IRS District did the same experiment with its Agents handing out a problem and then finding out each Agent had a different answer for the same set of facts. The tax code has become ruined with assorted pitfalls, traps and rewards often based upon assorted special interest lobbying groups. It just goes to show how the Government can not be relied upon to do anything that truly benefits the people. Taxes at the moment don't even bear any relationship with the debt as the spending is not lawfully aligned to tax collections. A true total mess brought to us all each and every election by the public of the United States.
I bet you a dollar do a dime that your explanation is PRECISELY why the Dems want DJT's taxes so bad....they'll go through it with a fine tooth comb and have some IRS Nazi that identifies with their agenda find numerous things "wrong" with them...and attempt to indict him for them...even though it's up to interpretation.
 

Thecrensh

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been there done that. was one of the pioneers in the galveston, tx market. then the market got swamped with amateurs......so i bailed
I had a former coworker whose brother had a beachfront house; they tried renting it out to high-end (read trust fund college students) clients...they trashed the place. He said it got so bad that the brother stopped renting and just sold the property.
 

edsl48

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I also own a business for 5+ years and starting another one this month, so I itemize everything.
Your business takes deductions under Section 162 of the Code along with a few other sections so in that respect you are not itemizing. Business deductions are amounts "for adjusted gross income" while "itemized deductions usually refers to amounts taken from adjusted gross income to yield taxable income. This is important because items deducted for adjusted gross income do not have to meet the limitations set upon individual itemized deductions.
I a not trying to fault your reasoning but rather, once again, reflecting on the impossibility of the tax laws resembling anything with common sense anymore)
 
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edsl48

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that covered it! this, on recovering the property taxes:

If You Don’t Itemize
If you don't itemize your deductions on your tax return, you won't be able to deduct the property tax and interest expenses you incur from owning vacant land. In this event, you should elect to add these expenses to your land's cost basis. This will reduce any taxable profit you earn when you sell the property.
Bear in mind that capital gains receive favorable ta rates so due to the mechanics it would be better to claim a deduction if one can today rather than capitalizing the amounts. 0n the one situation above I said I would advise claiming the deduction based upon the individual owning rental property already hence was in the real estate ownership business. Buying land and holding it would be different for one not in the business. Now if you owned a few acres of farm ground and rented it out that would be a schedule F item as you would now be a farmer.
 
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EO 11110

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Bear in mind that capital gains receive favorable ta rates so due to the mechanics it would be better to claim a deduction if one can rather than capitalizing the amounts. 0n the one situation above I said I would advise claiming the deduction based upon the individual owning rental property already hence was in the real estate ownership business. Buying land and holding it would be different for one not in the business. Now if you owned a few acres of farm ground and rented it out that would be a schedule F item as you would now be a farmer.
so if you own/run rental property you can contribute to an ira (as if it was earned income)? i.e. - that makes you a real estate professional?
 

edsl48

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so if you own/run rental property you can contribute to an ira (as if it was earned income)? i.e. - that makes you a real estate professional?
Actually not in most rental income activities because most seek to have an income that is exempt from having to kick in to the Social Security system. So, by being engaged in an activity for profit or more commonly supplemental income, one escapes the confiscation realities of Social Security but also doesn't get a few of the benefits either.
Believe me in most cases of owning a few rental properties avoiding Social Security is a tremendous benefit for most people. Consider that for the self employed the business owner pays both the employee share as well as the business share of Social Security and Medicare that is a bit over 15% at the moment for earnings up to 128,000 (with out looking up t he rates). Early in the game most landlords have a paper loss with positive cash flow due to depreciation but in later years are profitable. Imagine being retired and the Government snatching parts of your income for Social Security coverage...a great reason to be in an activity engaged for profit rather than in a trade or business.

Read the IRS blah blah on it here https://www.irs.gov/businesses/smal...oyment-tax-social-security-and-medicare-taxes