The tax breaks associated with owning rental property are one of the most significant reasons for choosing to purchase real estate in the first place. Real estate investors who actively participant in the management of their properties are often able to deduct substantial losses on paper while making an actual cash profit from their properties.
For tax purposes, all income-generating activities are classified as either active or passive. Most investments, including real estate, are considered passive investments by the IRS. The distinction is important because passive losses cannot be deducted against active income, except for a few specific circumstances. One such exception exists for individuals who own more than 10 percent of a rental property and actively participate in managing the property, such as selecting tenants, making repairs and making other management decisions. Another exception exists for real estate professionals, who are defined as individuals who work at least 750 hours per year in real estate activities and for whom real estate comprises more than half their work for the year.
Depreciation is the magical tax deduction that turns cash rental property profits into paper losses on your tax return. Depreciation is meant to account for the anticipated drop in the value of an asset over time. Different types of assets are considered to have different usable lifespans. For example, cars are depreciated over a period of five years. Residential rental property is depreciated over a period of 27.5 years, and commercial property is depreciated over the course of 39 years. In effect, this means that you can write off 3.63 percent of your acquisition cost of a residential property each year. This can create an annual tax deduction worth thousands of dollars per property, which not only helps offset rental income, but also creates a loss that can help reduce your overall taxable income. Only the value of the building itself can be depreciated. The value of land is subtracted from the depreciable value.
In addition to depreciation, you may deduct other "ordinary and necessary" expenses associated with rental real estate. While you cannot deduct your entire mortgage payment, you can deduct the mortgage interest, just as you can for a home that you live in yourself. You can also deduct the property taxes, hazard insurance, homeowner's association dues, and any utilities that your tenants don't pay. Repair and maintenance items, such as replacing broken windows, fixing clogged toilets, and repairing the furnace, may all be deducted directly in the year you make the repair. Renovations or improvements, however, are added to your basis and must be depreciated over the same time period as the rest of the building. A bathroom or kitchen renovation, new roof and even all new carpet are all examples of items that must be depreciated rather than deducted.
While real estate investing can provide ample benefits, there are, of course, limitations on the government's generosity. The two primary issues are passive activity loss limits and depreciation recapture. Although individuals who actively participate in their passive rental activities can deduct losses against their other income, this loss is limited to $25,000 per year. Your loss limit decreases by 50 cents for every dollar that your modified adjusted gross income exceeds $100,000, and thus disappears entirely at a MAGI of $150,000. If you ever sell a rental property, you're also subject to taxation on your profit from the sale, which can include the sum total of all the depreciation you've ever claimed on the property. Depreciation reduces your basis in the property, and so increases your capital gain when you sell, referred to as depreciation recapture.
Jassen Bowman is an IRS-licensed enrolled agent who specializes in IRS collections representation, small business tax law and international tax treaties. He has also served as a licensed real estate broker and investor. Bowman holds a Bachelor of Science in nuclear engineering technology.