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Is Now The Time To Consider a Real Estate Rental Property?

Does the recent decline in real estate values present a business opportunity?  Real estate rentals historically have been a popular long-term investment, and if you believe that this market eventually will rebound from its current slump, this may be the time to consider such an investment.  Let's look at some of the tax ramifications of renting both residential and commercial real estate.

First Things First

What is a rental property? To qualify as a rental property, the IRS requires that the property be rented out for a minimum of 14 days per year and that the owner not use the property for more than 14 days annually or 10% of the total rental days, whichever is greater.

Depreciation Deductions
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 and allow you to deduct your largest expense - the purchase price.  Federal and state income tax laws provide the owner with improvement depreciation on the purchase price taken over 27.5 years for residential properties and 39 years for non residential real estate.  This depreciation means that even though the investors property may increase in value, s/he can still take an annual depreciation deduction. To gain even more benefit on a shorter time horizon, investors can consider using cost segregation to split the property depreciation from items like appliances or furniture, which can be depreciated over five years. 

 

Appreciated Tax Benefit

Another historical benefit of real estate rentals is capital appreciation.  If the rental property increases in appreciated value, not only is the appreciated portion not taxable but the investor can also borrow using the appreciated value as collateral. The borrowing and the collateral are still not taxable.

 

Before acquiring a rental property, there are several things to consider, including

  • after-tax cash flow,
  • potential for long- or short-term appreciation,
  • property condition (with eye on when you might get stuck with a large repair bill)
  • debt reduction,
  • type of tenants,
  • protential for rent increases or re-zoning, and
  • whether there is community rent control, etc.

The IRS advises property owners to keep careful records of all expenses, improvements and related activities. These will all be reported on Schedule E, Supplemental Income and Loss.


Business Tax Deduction

Rental real estate income is business income but is not subject to Social Security taxes.  Where you might be renting to your business, you generally want to structure the rent to be as high as you can reasonably make to save social security. Real estate rentals are also considered passive investment activities.  Generally, passive activity losses are deductible only to the extent of passive activity income.  However, where there is active participation by the taxpayer in managing the rental, the taxpayer can deduct up to $25,000 of losses each year as long as his or her Adjusted Gross Income (AGI) for the year is less than $100,000.  For higher-income taxpayers, the $25,000 loss exception is ratably phased out between an AGI of $100,000 and $150,000.

 

Some individuals may qualify as real estate professionals' under the tax code and would negate the 'passive activity income' and qualify for real estate activities to be deductible as business expenses.  The investor must make real estate management their principal work activity, but could then take usual and customary business expenses as deductions related to the work. 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.  To the extent your passive losses from an activity are not used up in this fashion, you will be allowed to use those losses in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.


Buying, operating, and selling a rental property can have profound tax ramifications and provide some interesting options not available to other investments.  Please contact your accountant or tax advisor prior to the purchase or disposition of a rental property so that the tax impact can be analyzed prior to making a financial commitment.

 

Steven A. Feinberg, CPA - www.AppletreeBusiness.com

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