Is Now the Time to Consider Rental Property?
Does the decline in real estate values present a business opportunity? Real estate rentals historically have been a popular long-term investment, and if you believe that this market eventually will rebound from its current slump, this may be the time to consider such an investment. This material will explain some of the tax ramifications of renting both residential and commercial real estate.
One of the biggest benefits of owning rental property is that the tenants, over time, buy the property for you. In addition, if structured properly, the allowable depreciation deduction will shelter the rental income. Another historical benefit of real estate rentals is capital appreciation. Before acquiring a rental property, there are several things to consider, including:
• after-tax cash flow,
• potential for long- or short-term appreciation,
• property condition (with an eye on when you might get stuck with a large repair bill),
• debt reduction,
• type of tenants,
• potential for rent increases or re-zoning, and
• whether there is community rent control, etc.
Although most of the considerations are subjective, the after-tax cash flow can be estimated fairly easily, as illustrated in the example below.
In this example, there is a column for actual cash flow (after taxes) and another for reportable tax profit or loss. For actual cash flow purposes, we must consider the entire mortgage payment (interest and principal), while for the rental tax P&L, only the interest is deductible, but an allowance for depreciation is included. As a result, in the example, there is a negative cash flow of $1,300. However, for tax purposes, the rental shows a loss of $4,550, primarily because of the depreciation allowance. Assuming that the taxpayer is in the 25% tax bracket, that $4,550 loss yields a $1,138 savings in taxes for the year. Thus, our after-tax cash flow is negative only by $162. You also will need to consider whether your loss deduction is limited by the passive loss rules. Generally, you can deduct virtually all expenses incurred to operate and maintain (not improve) the rental. Improvements must be capitalized and depreciated.
Rental real estate income is business income but is not subject to Social Security taxes. Real estate rentals are also considered passive activities. Generally, passive activity losses are deductible only to the extent of passive activity income. However, where there is active participation by the taxpayer in managing the rental, the taxpayer can deduct up to $25,000 of losses each year as long as his or her Adjusted Gross Income (AGI) for the year is less than $100,000. For higher-income taxpayers, the $25,000 loss exception is ratably phased out between an AGI of $100,000 and $150,000. There is also a special allowance for real estate professionals. Any losses not allowed under these two exceptions are not lost but suspended and carried forward indefinitely to tax years in which your passive activities generate enough income to absorb the losses. To the extent your passive losses from an activity are not used up in this fashion, you will be allowed to use those losses in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.
When a rental is sold, it is treated as a capital asset, and the gain, except for depreciation recapture, is taxed at capital gains rates. Recaptured depreciation, depending upon your tax bracket, can be taxed up to 25%. Besides outright selling of a rental, there are a number of options such as exchanging the existing rental for another while deferring the gain and avoiding current taxes, selling the property in an installment sale (which spreads the taxable gain over multiple years), or even converting the property to personal use (which forestalls the taxable gain until the property ultimately is sold).
Buying, operating, and selling a rental property can have profound tax ramifications and provide some interesting options not available to other investments. Please contact this office prior to the purchase or disposition of a rental property so that the tax impact can be analyzed prior to making a financial commitment.
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