Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part V. Real Estate Income and Deductions

Chapter 24. Real Estate Income and Deductions

A Uniquely Taxed Business

In many ways, the taxation of real estate is just like the taxation of any other business. In fact, if you are involved in the real estate business, Chapters 18, 19, 21, and 22 in Part 4 of this book are required reading. The same rules that apply to a business regarding travel expenses, meals, depreciation, and so on apply also to the real estate business.

With that said, there are also many ways in which real estate businesses are taxed that are unique. These nuances bring with them tax strategies geared toward the real estate business. Several of these unique features are focused on in this chapter, including:

·     Rent recognition rules

·     Allowable expenses

·     Repairs vs. improvements

·     Depreciation

·     Travel

·     Self-renting

Rent Recognition Rules

There are a few things to be aware of regarding the recognition of income for rental property. First, if you receive a payment for rent in advance, you must recognize that payment as rental income in the year that you receive it, no matter which method of accounting (cash or accrual) you use. This can occur when a tenant pays several months of rent at a time, pays “first and last month’s rent,” or even with the payment of a security deposit. Even though a security deposit may be paid specifically toward the possibility of future repairs, not rent, and is refundable, it is counted as rental income when received. The only way that this tax treatment of a deposit can be avoided is if the owner has no control over the money in any way, such as a deposit in a third-party escrow account. Another example of a payment that must be recognized in the ­current year is if a tenant pays a fee to get out of a lease early—even if the fee is for a rent commitment in a future year.

Second, if a tenant provides services or property in trade for rent, the fair market value of those services or property must be recognized as rental income. Generally, if you agree on a price for those items, the price will be recognized as the fair market value (unless the price is unreasonably different than what would be paid on the market). For example, if a tenant agrees to maintain the landscaping of the rental in trade for a $150 reduction in rent each month, the $150 difference must be recognized as income.

Third, if a tenant makes improvements to the property you do not recognize income for the value of those improvements, unless the improvements are done in trade for rent. For example, an acquaintance of mine recently replaced a fence on the property of the home he rents in order to keep his dog contained in the yard without being on a leash. The landlord was willing to let him put up the fence, but didn’t reduce his rent as a trade for the service. Because of this, the landlord does not need to recognize any rental income for the fence. However, the landlord’s basis in the fence is $0 and he is not able to claim any depreciation on the new fence as an asset.

Fourth, if a tenant pays your expenses directly, such as making payments for repairs, mortgage payments, property tax payments, insurance payments, or utility bills that are in your name, you must recognize those payments as income. The good news is that you can also recognize the expenses to offset the income on the return.

Finally, if you receive insurance proceeds for a loss of rental income, those proceeds are counted as rent.

Allowable Expenses

As with any business, expenses that are directly related to the rental property and that are considered “ordinary and customary” are generally allowable as deductions from rental income on your tax return. There are, however, two important exceptions to this rule.

First, to deduct expenses for a rental, the property must be actively held out for rent. If you do not have tenants for a given time period you must be able to show that you were actively seeking to have tenants during that time—otherwise you cannot deduct expenses during that period. The easiest way to show that you were actively seeking tenants would be to provide proof of advertising the property for rent. If you have recently purchased the property and need to upgrade it before renting, the expenses you incur before putting it up for rent must generally be included in the overall cost of purchasing and buying the house (subjecting those expenses to depreciation).

Second, if the property has multiple uses or dwellings you must split the expenses between those uses or dwellings as best as you possibly can. For example, if you own a duplex and live in half of it and rent out the other half, you would deduct only half of your mortgage interest and property taxes and so on.

If an expense is not directly related to a specific portion of the property (such as repairing a broken window on the rented portion) then you can divide up the cost in the way that most accurately reflects the correct allocation. Often the best way to divide up general expenses is by square footage. For example, if the rented portion of a property is 400 square feet and the non-rented portion is 600 square feet, then 40% of the general expense would be assigned to the rental. At other times the percentage-of-square-feet method may not be appropriate. For example, if a portion of the space is occupied by a welding shop and the remaining space is used as a warehouse, it is likely that the ­majority of the electricity used in the building belongs to the welding-shop space.

Though there are too many possibilities to list all deductible rental expenses, the following list provides a glance at many of the common expenses that are incurred in the rental business:

Advertising

Insurance

Pest Control

Association Dues

Legal Fees

Property Taxes

Bank Fees

Licenses

Repairs

Bookkeeping

Maintenance

Supplies

Cleaning

Management Fees

Tax Accounting

Commissions

Mortgage Interest

Telephone

Decorating

Painting

Travel Costs

Gardening

Permits

Utilities

If you rent the property for less than fair market value (e.g., to help a friend), you cannot deduct more expenses than the rent (i.e., there is no loss available, not even as a carryover). However, there is an exception that allows you to rent a property to a family member for below-market rates, up to as much as 20% lower than market value.

Repairs vs. Improvements

Whenever possible (and accurate), it is best to categorize changes to the physical aspects of the property as repairs instead of improvements. The reason for this is that repair expenses can be deducted in the year they occur, whereas improvements must be depreciated over a number of years (as much as 39 years, depending on the type of property and the improvement).

The main distinction between the two is that repairs are made to keep your property in good operating condition, whereas improvements are those made to add value to the property, prolong the life of the property, or change its use. Repairs that are made as part of an overall improvement program may not be deducted as repair expenses, but must be included in the overall cost of the improvements. The following list illustrates the difference between some common repairs and improvements:

Repair

Improvement

Fix a broken window

Upgrade a window

Paint a wall

Add a wall and paint it

Reseal an asphalt driveway

Pave a driveway

Repair a leaky gutter

Install a new gutter

Replace a damaged carpet

Replace carpet with hardwood

Fix a broken lock

Install dead bolts

Repair a broken fence

Completely replace a fence

Repair a leaky roof

A new roof before leaks arise

Depreciation

Depreciation for rental properties follows the same basic rules as other depreciable items as outlined in Chapter 22. However, there are two important things to be aware of when considering depreciation of real estate. First, land cannot be depreciated. For every property you must allocate an appropriate amount of the purchase price to the value of the land, and only the remaining amount may be depreciated. Use the appraisal of the property as the source for the land’s value. If you did not get an appraisal, most property tax statements from the county show an estimated value for the land. While the county’s value is usually not as accurate, it will be close enough and likely acceptable to the IRS. A third method is to assign a percentage of the property value to the land based on surrounding properties, but this method should be used as a last resort.

Second, when making improvements to a property, it can be very valuable to itemize the labor and materials costs of each facet of the improvement. Individual improvements are subject to a wide variance in the number of years of depreciation that is required, and by separating out each individual expense you would likely be able to depreciate the overall cost at a much faster rate, resulting in lower taxes in the near term. In contrast, if all of the expenses are lumped into one large improvement, the depreciation must be spread out over the life time of the property. If the costs of improvements are significant, the difference between itemization and lump sum depreciation can really add up.

image   Example   A new carpet installed in a residential property can be depreciated over a five-year period. However, if many improvements are made to the property at the same time and the cost of the new carpet is included in the overall total cost of the improvements, it will have to be depreciated over a period of 27½ years. Depreciating a $2,000 carpet over five years allows for $400 of depreciation each year, whereas depreciating it over 27½ years would allow only $73 of depreciation per year.

Travel

To understand fully all of the rules that govern travel expenses, be sure to read Chapter 18. With that in mind, one popular strategy that real estate owners employ is to purchase rental properties in places where they already travel with their families, in order to be able to write off those travel expenses on their tax return. For example, if your parents live out of state and you normally visit them twice each year, you could buy a rental property near their home and use those trips to also check on the property and make any needed repairs or maintenance while you are there. If you follow all of the rules governing travel costs, this could be a very effective way to transfer a non-deductible, personal expense over to a deductible expense on your tax return.

images   Caution   This strategy must be weighed against the non-tax issues that landlords face when owning property that is far from your home. The expense that comes with hiring a property manager (assuming you wouldn’t if the property were nearby) may outweigh the tax benefits of writing off the occasional travel expenses.

Also, if you want to employ this strategy by purchasing a rental property that you will actually use for vacations, be sure to read the additional rules that apply to such situations that are outlined in Chapter 25.

Self-Renting

One interesting tax reduction strategy that some individuals employ is to rent their property to a business that they own. Doing so allows business income to be changed into passive income, potentially reducing taxes. By renting to your business you create an expense for the business, which reduces earned income and, for sole proprietors, the self-employment tax. In turn, the rent increases passive income. However, this increased income is not subject to the self-employment tax. In addition, the increased passive income could be used to offset additional passive losses from other properties that might otherwise have to be carried over to future years.