RENTAL REAL ESTATE AS AN INVESTMENT

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 such as whom to rent to, the rental terms, approving capital expenditures, etc. You also can show active participation if you 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.

“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.

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.

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. The following is a list of 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 (1) – 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 later.
• Local transportation expenses
• Homeowners or association dues
• Tax return preparation fees
• Depreciation allowance – see depreciation later.

(1)If any individual or company providing these services is paid $600 or more during the year, you are required to issue them a 1099MISC.

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%.

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.

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. For example, if you paint the room that you rent or pay premiums for liability insurance in connection with renting a room in your home, the entire cost is a rental expense. If you install a second phone line strictly for your tenant’s use, all of the cost of the second line is deductible as a rental expense. You can also deduct depreciation on the part of the property used for rental purposes, as well as on the furniture and equipment used for that purpose.

Generally, the most frequently-used methods of allocating expenses between personal use 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. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them.

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.

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?

• 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. Repainting your property inside or out, fixing gutters or floors, fixing leaks, and replacing broken windows are examples of repairs. However, if the repairs are part of an extensive remodeling or restoration of your property, the whole cost is an improvement.
  
• 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. The capitalized cost can generally be depreciated as if the improvement were separate property.

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.

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.

Reasons to Exchange: Structuring a transaction so that it meets the requirements of Section 1031 can offer many benefits to a taxpayer, including:

(1) A taxpayer can acquire a property without the availability of a great deal of cash.
(2) A tax-free exchange allows greater creativity to a taxpayer in converting a business property into personal-use property. The exchange allows a taxpayer to acquire a property suitable to personal use prior to conversion.
(3) Exchanges put off the payment of tax on a transaction. The effect is like getting an interest-free loan from the government.
(4) The problem of “excess of mortgage over basis” is avoided. When a mortgage exceeds basis, the excess is ordinary income in the year of sale when the installment method is used. This is not true with an exchange.

Business or Investment Use Requirement - To qualify for a Sec 1031 exchange, the properties exchanged must both be held for business or investment use.

Like-Kind Requirement - The properties exchanged must be like-kind (similar in nature, but not necessarily of the same quality). Real estate must be exchanged for real estate (improved or unimproved qualifies).

Caution: Sometimes real estate is held in a partnership or other entity. Generally, an entity ownership does not qualify as like-kind. Although, tenant-in-common interests (sometimes referred to as TICS), if structured properly, can. Please contact this office for details.

Property Acquired with Intent to Exchange - If a taxpayer acquires (or constructs) property solely for the purpose of exchanging it for like-kind property, the IRS says that the taxpayer doesn’t hold the property for productive use in a trade or business or for investment, and as to the taxpayer, the exchange doesn’t qualify for non-recognition treatment under Code Sec. 1031.

Simultaneous or Delayed - The exchange can be simultaneous or delayed. If delayed, the property received in the exchange must be identified within 45 days after the property given is transferred. No matter how many properties are given up in an exchange, a taxpayer is allowed to designate a maximum of either:

(a) Three replacement properties regardless of FMV, or
(b) Any number of properties, as long as the total FMV isn’t more than 200% of the total FMV of all properties given up.

If a taxpayer identifies replacement properties over these limits, he/she is treated as if none were identified. A taxpayer can, however, revoke an identification at any time before the end of the 45-day time period.

The receipt of the new property must be completed before the EARLIER of:

(1) 180 days after the transfer of the property given, OR
(2) The due date (including extensions) of the return for the year in which the property given was transferred.

Qualified Intermediary – Generally, to qualify for a delayed Sec 1031 exchange, a qualified intermediary is engaged to hold the funds from the sale until the replacement purchase is made. It is important to understand that the taxpayer cannot take possession of the proceeds form the sale and then buy another property. If that happens, the event does not qualify for exchange and is immediately taxable.

Reverse Exchanges – It is possible to structure a reverse exchange that complies with the Section 1031 delayed exchange requirements. However, it requires that the replacement property be purchased first, by the intermediary, without the benefits of the proceeds from the property given up in the exchange. Thus, only taxpayers with the cash financial resources can accomplish reverse exchanges.

Tax-deferred exchanges can be very tricky and should not be entered into without first analyzing the tax aspects. Exchanges are actually equity exchanges, and if a taxpayer reduces their equity position (takes out cash or boot in the exchange), then the gain might not be deferred and the expense of structuring an exchange wasted. As a rule of thumb, if a taxpayer moves up in property value and up in equity in the property, there is a taxable event. Please call this office before initiating the transaction.

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.

Rented less than 15 days - If you rent the property out for less than 15 days during the year, the property is not treated as a rental. Any rents received are not includable in income no matter how substantial the income might be, and no deductions are allowed other than property taxes and mortgage interest deducted as an itemized deduction subject to the normal limitations. No other operating costs and no depreciation are deductible.

Rented 15 days or more AND the taxpayer’s personal use is less than 15 days or less than 10% of the rental days - Allocate expenses according to personal vs. rental days. No further limitation is necessary (except the usual “not-for-profit” rules must be considered). A loss can be claimed.

Taxpayer use is 15 days or more and over 10% of the rental days - First allocate expenses by personal vs. rental days, as in the previous paragraph. Deduct allocable taxes and interest first, then maintenance and other cash expenses and then depreciation until the net is ZERO. A loss cannot be claimed.

When determining the personal-use days, do not include days where you are there to perform repairs or to fix up the property.

This is a generalized overview of the “vacation home rental rules.” There are other subtle points in the law related to vacation home rentals. Please contact this office before drawing any final conclusions.