One of the most complicated areas of tax policy is rules on rental properties. While I won't pretend to give you an exhaustive list of rules (for that you will need to consult IRS Publication 527), this is a pretty good brief primer.
There are complications involving what is rent, what are legitimate expenses, when to take a loss, depreciation, and sales of the asset.
Everyone who receives rental income must pay tax on this income. This income is subject to the income tax only--it is not considered a trade or business, so FICA/SECA is not an issue.
Rent is both actual cash and the fair market value of in-kind services performed.
Over and against this income, though, taxpayers are entitled to deduct rental expenses. These include but are not limited to:
- mortgage interest
- property taxes
- condo fees
- homeowner association fees
- property management fees
- utilities paid by the landlord
- costs of servicing the property, like travel and transportation
- other interest paid related to the property
If a property is mixed-use (like a two-bedroom apartment owned by one person and renting to his roommate), the rental and personal expenses are divided reasonably. Note that while virtually all expenses associated with a home are deductible for rental purposes, only mortgage interest and property taxes are deductible for personal purposes.
Rather than immediately expense the cost of a rental property, the tax code requires you to slowly deduct (or depreciate) the property over many years.
In the case of a residential rental property, the depreciable life is 330 months (27.5 years). In the case of a non-residential rental property, it is 468 months (39 years). If you are in AMT, the depreciable life is 480 months (40 years). In all cases the mid-month, straight-line convention applies.
The basis for depreciation is usually the lesser of the cost or the fair market value at the time it was placed in service as a rental property.
Depreciation is not optional. It must be taken as a rental expense.
Because depreciation is a "paper" expense, inclusion of it in rental expenses usually generates a rental loss on paper. In general, rental losses are not allowed to taxpayers. Rather, accumulated losses "roll over" to the next year. They are only used when:
- There are sufficient rental profits to use up the "bank" of accumulated losses, or
- The property is sold, in which case unused losses are immediately realized
There is an exception to this for moderate-income taxpayers who materially and actively participate in the rental property. In the case of a taxpayer with an AGI of less than $100,000, up to $25,000 in losses is realizable in a given year. This phases out ratably until AGI hits $150,000, where no loss is allowed (these figures are halved for married filing separately taxpayers).
No loss is ever allowed if the property has been used for personal use the greater of 10% of the days rented or 14 days in a year.
Another exception is for rental real estate professionals (more than 750 hours of rental activities in a year). There are no loss restrictions for these "professional landlords."
For the sake of this discussion, I will assume that the property is sold for a gain.
The best way to deal with sales is to use an example:
Property X was purchased in 2003 for $100,000. It was immediately placed in service as a rental property. 24 months later, the property is sold for $120,000.
In that time, 23 months of depreciation has been claimed (23 x 100,000/330), or $6970 (23 because the first and last months are half-months according to the depreciation rules).
This reduces the basis in the property from $100,000 to $93,030. Therefore, the taxpayer has two gains to worry about--getting back to the original $100,000, and accounting for the $20,000 of actual gain.
The first gain (getting back to $100,000) is known as "depreciation recapture." It is taxed at a flat rate of 25% for most taxpayers. If the taxpayer sells at a loss, that loss amount eats into the depreciation that must be recaptured.
The second gain is ordinary capital gain. The maximum rate for this is 15% for assets held longer than a year.
It's important to note that if the taxpayer converts a rental property to personal use and then sells it later (qualifying for the 24/60 month ownership and use tests) and can exclude up to $250,000 of gain (double that for married), this only affects the second gain. Any depreciation claimed after May of 1997 is not eligible for the exclusion and must be recaptured to the extent there is a gain on the sale.
Whew. So that's rental real estate rules. Don't go it alone.