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PostHeaderIcon Rental Real Estate Taxation Basics

While I continue to fret over my “about me” page, one of the things people ask me is, “What is your specialty?”  Over the course of my 18+ year career in tax, to a certain extent, I’ve done it all.  I’ve worked on billion dollar bank and insurance companies and large multinational manufacturing companies all the way to the businesses that bring their receipts in a shoe box.  Still, for most of the past ten years I’ve been immersed in real estate.  They’re not the only clients I work on but it’s become a niche I’ve embraced.  This includes big real estate (I spent over five years in the tax department of a publicly traded REIT) to local real estate working with investors mostly in the Detroit-metro area.  You’ll also find that a lot of the content on this site is real estate related.

One of the things I haven’t touched on in a post is the taxation basics of rental real estate.  If done right, rental real estate can be a great investment but when you take into consideration some of the favorable tax rules that surround it, it can definitely be something you want to look at to add to your portfolio of investments.

First off is the disclaimer. I’m going to making a lot of general statements but as always, everyone’s tax situation is unique so be sure to consult with a professional before you put any of this advice in place.

The first question I usually get asked is about entities.  I’m going to focus on just the tax implications and leave the entity protection discussion for your attorney.  If you want to buy and hold real estate, most of the time you’re going to hold it in a non-corporate entity.  If you want to read about why you probably don’t want to hold real estate in a corporation, I discussed that specific issue in a separate post.  Most of the time you’ll be dealing with a limited liability company (LLC).  If it’s a single member LLC, you’ll be reporting your rental real estate activity on Schedule E of your 1040.  If its a multi-member LLC, then the default tax form is the Partnership Return, which is Form 1065 with the specific rental activity being reported on Form 8825.

The next question I’m usually asked is “What can I deduct?”  The IRS’s general rule is an expense has to be ordinary and necessary expense in carrying on the  trade or business.    As usual they like to keep things vague but the first bucket of expenses are what I call the Big Three.  This is your interest, insurance and taxes.  Rental real estate will almost always have insurance and taxes and if there is leverage involved, you will have interest as well.  In dollar terms, those three expenses usually make up the bulk of you cash outflows.  If you hire a property manager, that is also a deductible expense.  Repairs (not to be confused with capital improvements) can also be deducted as can utilities if that’s a cost you incur on behalf of your tenants.  Costs to advertise the property are also deductible and you can also deduct your mileage if you’re making trips out to the property (within reason). You can also deduct legal and other professional fees (accounting and tax as an example) as well.

I mentioned repairs and you have to distinguish between a deductible repair and a capitalized capital improvement.  Lets use a roof as an example.  If you have someone come and patch up your roof, it’s probably something you can deduct. If you’re replacing the entire roof, that would probably fall more into the improvement category and you should capitalize it and depreciate it over its useful life.

Which leads me into depreciation.  When you buy a piece of real estate, you buy several different things.  You get a building, you get land and unless the house is gutted, you also get a lot of fixtures, pipes and wires.  You have a couple of choices when it comes to depreciating your property.  One option, although it’s usually not cost effective for single family homes, is a cost segregation study.  When you do a cost seg. study, you really break down the cost of what you’re buying and the end result is, you usually get property that you can depreciate over a shorter useful life (i.e. more depreciation expense now) versus property you can depreciate over a longer life (less depreciation expense now).  The other option is to just go with an estimate like an 80/20 split between property and land with the 80% being depreciated over 27.5 years.  You don’t get to take advantage of the quicker depreciation tables but you also have to spend less administrative time and money to break everything down.

When you prepare your taxes, the calculation isn’t that challenging but you have to make sure you fill out the form completely and accurately.  You take your rental income and subtract your cash expenses and your depreciation to come up with a net number.  If it’s a positive number, it’s either reported on your 1040 or it will flow through from your Form 1065 via a Schedule K-1.  If it’s a loss, then it gets a little trickier because the passive activity loss rules can get complicated.  I will save how and when you can take these losses for a post of its own.

Hopefully this is enough to get you started or if your already renting property, it validates what you’re doing. There are some other strategies I’d like to talk about, including ways to set things up if you own multiple properties, but this is getting a bit long and I will save those as well for a future piece.  As always, if you have questions, you can find a few different ways to contact me on my contact page or if you have a comment, feel free to leave one here.

PostHeaderIcon Renting Your Home

Let’s start with a case study to set this up.  You live in the Detroit area so let’s assume a major sporting event is coming back to town like the U.S. Open and they’re holding it at Oakland Hills.  You’re lucky enough to own a home less than a mile away from the golf course and an international financier agrees to rent your house for an obscene amount of money to live in your house for the week.  You move into a local hotel and a week later, you move back into your house.  Tax time rolls around and now you’re worrying about how to report this on your taxes.

Fortunately, the answer is, you don’t have to do anything.  If you rent your home (or your vacation home) for less then 15 days, you don’t have to report it all.  There is no income limit so if someone was stupid enough to pay your$100,000 to rent your house for a week, you wouldn’t have to show it anywhere on your tax return.  The safe harbor period is two weeks. As long as you rent your home less than 15 days, then no reporting is required.

Things get a trickier if you rent your house for a longer period of time.  Then it’s a big proration exercise.  So if you spend $2,400 on property taxes that’s $200 a month and if you rent your house for the four winter months, then $800 would be reported as a rental expense and the rest would show up on Schedule A if you itemize.  This also creates some extra reporting when you sell your house because if you qualify for the principal residence exclusion, you’ll have to recapture and pay tax on any depreciation you took while renting out the house.

PostHeaderIcon Holding Real Estate In a Corporation

Many people feel that the two absolutes in life are death and taxes.  In my experience, if there’s something that comes to close to a third absolute it’s that you should never hold real estate within a structure that’s taxed as a corporation.  I can give you some examples of where it works out okay but still not as well as under a structure taxed as a partnership but I can give you a few different examples of where you can have some disastrous tax circumstances when holding real estate in a corporation.  The primary pair of reasons are basis rules and distribution rules.  As always, I’m keeping this simple so if you have a specific situation that applies to you, be sure to contact a professional.

Let’s say you get a great deal on a property.  You’re able to buy a $1 million piece of property for $500,000 and because of the great purchase price, you’re able to finance the entire $500,000 with  a bank loan.  Let’s take a look at what happens in two years when you try to distribute this piece of property out of your legal entity.

If you bought the property under an LLC that’s taxed as a partnership, you’d be in pretty good shape.  You’d probably (it would depend on the bank note) be able to pass through any losses from the partnership because your debt has given you basis.  In two years, if you distribute the property out of the LLC, it’s a tax free transaction and the property would come through with its basis and carrying period intact.

If you bought the property under a C-Corporation, you’d have a mess.  When you distribute property, it’s the same as if you sold it then distributed the proceeds so you’d have about a $500,000 gain that the C-Corporation would have to pay (plus any depreciation that you took in those two years).  On top of that, the distribution would be taxable to the shareholder at the value of the property or in this case, $1,000,000.  Those two layers of tax that will chew into that $500,000 in savings you picked up when you bought the property pretty quickly.

While not as bad as the C-Corporation example, if you had put it under a corporation that had made a Subchapter S election, you’d still have some tax to pay.  You wouldn’t have any basis in the corporation because the debt from the bank note isn’t eligible as basis.  You’d have the capital gains hit that would occur at the S-Corporation level (which would ultimately flow through to the owner’s personal return) but not the second layer of tax because the dividend would come through half tax free and half as a taxable S-Corp distribution because you’ve established some basis when the capital gain was taxed but not enough to cover the entire $1 million.

In short, putting into an LLC is pretty much a no lose situation.  Putting into a corporate structure, you could have a tax mess on your hands.  Be sure to discuss your personal situation with you tax adviser.

PostHeaderIcon The New Form 1040, Schedule E

I’ll get to how in a second, but this post ties in nicely with yesterday’s piece on Form 1099-MISC.  The IRS revamped their Schedule E, that’s attached to your Form 1040 if you have either rental properties or you own an interest in a flow through entity (LLC and S-Corporations are the big two) where you receive a Schedule K-1.  Page two is used to report your flow through entity activity and that’s largely unchanged.  Page one has new stuff on it and it’s worth examining further.

The first big change is at the very top of the form where they now ask you two questions and both relate to Form 1099 requirements.  In the famous words of Admiral Ackbar, “It’s a trap!!”  The two questions seem innocent enough but what the IRS is basically trying to do here is make sure you’re meeting the newer (although they’ve always been around, the IRS just seems to be focusing on them) rules that require property owners to issue 1099s.  If you operate your rentals under a business structure you probably should have been doing this anyway but now the IRS is on the prowl with regard to this particular issue.

The trap on Schedule E works like this.  Say you’re preparing your return in April and you get to your Schedule E.  You say to yourself, “I’ve never done 1099-MISC’s before, I’m not going to start this year plus it’s already too late,”  so you check “no” to each question.  The problem is, you’ve also reported $800 in professional fees, $1,300 in repairs and $2,000 in management fees, odds are some of those went to an LLC or a self-employed individual (you’re still not required to send corporations a 1099, we dodged that bullet when Congress repealed that provision that was in the health care law.  So by saying no to those questions AND reporting those deductions, you’ve now increased your chances of hearing from the IRS.  So beware and if you’re reading this now, either read up on (yesterday’s post is a quick primer) or talk to your adviser about getting out some 1099′s.

The other change to the schedule is line 3a.  The IRS added a line to separately report income reported on the new Form 1099-K.  If you take credit card payments or receive money from a third party network such as paypal.com and you exceed the minimums spelled out in the instructions, then you’ll get a Form 1099-K this year.  If that 1099-K is for your rental, then that’s the line where you enter that information.

So that’s the new form.  If you want more information, you can find the schedule’s instructions here.