Tax Advantages of Owning Rental Properties

Renting real property provides you with tax advantages you may not have otherwise been entitled to claim. While you are required to report rental income, often expenses exceed the income, offering a potential tax deduction against other income. When structured properly, rental properties are capable of producing fully deductible losses on your taxes, while producing equity you will someday realize.

The Facts

You are required to report the income from your renters, which include advance rent payments. Because individuals are primarily cash basis taxpayers, late rent payments not received at the end of the year are not taxable during that year. Not all expenditures are immediately deductible for tax purposes. Substantial improvement or replacement that adds value to the property or prolongs the life becomes a fixed asset. Fixed assets are depreciated over their useful life rather immediately like an expense.

Trade or business activities you do not materially participate in represent passive activities. Passive losses do not reduce active income, and active losses do not reduce passive income. Wages and businesses you regularly operate are active activities. By definition, property rentals are passive income and losses; however, the Internal Revenue Service, or IRS, allows exclusion on losses up to $25,000.

Types

Tax advantages of owning rental properties include claiming expenses, depreciation and IRS elections that may reduce your tax liabilities. Deposits intended for return to renters are not taxable, although any portion not returned at the end of the rental period becomes rental income at that time. Rental properties can produce active and passive income and losses. Tax advantages come from both passive and active income and losses, if planned properly for your specific situation.

Considerations

Renting properties often results in a tax loss while mortgages are new. Mortgage payments include interest, which is the deductible portion of the payment, and often drives the activity into a loss. Property rentals producing positive cash flow may still result in a tax loss due to non-cash deductions including depreciation and amortization. Limitations on tax advantages exist for rental properties producing a taxable profit.

A tax loss on your rental property up to $25,000 produces a benefit by offsetting wages or other active income. The reduction in income minimizes your taxable income effectively diminishing tax owed. You estimate your tax reduction by multiplying your rental loss up to $25,000, by your highest tax rate.

Before purchasing multiple properties, consult your tax advisor to determine if your entire loss will be deductible.

Warning

Only $25,000 is deductible as active loss from rental properties per household. Married filers living together must not file separately to qualify and must actively participate in the rental activity. Active participation includes advertising the rental, approving tenants, collecting rents and approving expenditures for repairs. If a management company handles the property, or you do not actively participate, you cannot claim any losses as active. If your modified adjusted gross income, or MAGI, exceeds the Internal Revenue Service, or IRS, threshold you will not be able to deduct active losses. The IRS threshold can change annually.

Expert Insight

Losses exceeding $25,000 are not deductible as active income, unless you hold a valid real estate license, and it is your primary income-earning activity. Acquiring multiple properties that lead to both individual and aggregated losses in excess of $25,000 are fully deductible if you perform at least 750 hours in real estate activities in one year, and more than one-half your income producing activities are related to real estate activities. You or your spouse can hold a license and perform the work to earn the active classification increasing your deductions. You will then be able to exceed the $25,000 active loss threshold. You must make efforts to continue growth for your real estate activities.

References

• Internal Revenue Service. Publication 527: Residential rental property.
• Internal Revenue Service. Publication 946: How to depreciate property.

Resources

• National Association of Enrolled Agents