Real Estate Rentals As Tax Deductions
In the U.S., many taxpayers with rental real estate are able to benefit from a deduction for the net loss of the rental real estate activity on their individual income tax returns. This loss, which may be partially used to offset ordinary income, is often generated as a result of IRS deductions allowed for mortgage interest and depreciation of the property.
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Depreciation
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When an investor purchases rental real estate property, often the investor anticipates the property will increase in value over time, or, at a minimum, maintain the original value. The Internal Revenue Code, however, allows the purchaser of rental real estate property to depreciate the purchase price during the period of time the investor actively rents or seeks to rent the property. As a result, the investor may be able to claim a depreciation deduction in the value of the property for tax purposes while the market value of the property actually increases.
Function
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Under the General Depreciation System, the Internal Revenue Code allows investors to claim a depreciation deduction for residential rental property over a 27.5-year recovery period and for nonresidential rental property over a 39-year recovery period. Both residential and nonresidential rental property are depreciated under a method known as straight-line depreciation, which allocates an equivalent amount of depreciation over every year of the recovery period. The depreciation deduction is claimed on Form 4562, Depreciation and Amortization.
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Additional Deductions
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In addition to the depreciation deduction, property owners can also claim income tax deductions for a large number of other costs associated with their rental properties. These commonly include mortgage interest expense and related fees, the cost of cleaning and maintaining the property, repairs to the property, real estate taxes, property management costs, and the cost of advertising the property for rental.
Certain major improvements, such as a kitchen refurbishment, may not be immediately deductible, but they are considered "capitalized" and may be depreciated over a period of several years, just like the purchase price of the property.
Limitations
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The Internal Revenue Service (IRS) generally considers the rental of real estate to be a passive activity. As a passive activity, the ability to deduct any loss generated from rental real estate activities is generally limited. The IRS currently allows for an annual maximum of $25,000 of aggregate rental real estate losses that may be used to offset other forms of income. For taxpayers with modified adjusted gross incomes above $100,000, the maximum amount of $25,000 may be reduced.
Real Estate Professional
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Taxpayers who devote significant time to rental real estate activities may be able to avoid the passive activity limitations and can deduct the entire amount of aggregate rental real estate losses without regard for the $25,000 limitation. The IRS considers individuals with substantial rental real estate activities to be "real estate professionals," and passive activity loss limitations on real estate activities do not apply. There are a large number of requirements to be deemed a real estate professional; but, in general, real estate professionals spend more than 50 percent of their time each year in real estate trade or business activities, with more than 750 hours annually in these activities.
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References
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