There are obvious benefits to buying a rental property -- from rent revenue and asset accumulation to the potential capital gains when you eventually sell. But, before diving into the rental real estate market, there are also a variety of potential tax issues to consider.
This is generally the largest tax benefit for rentals; annual depreciation can offset a significant amount of rental income. The Internal Revenue Service allows you to write off a portion of the purchase price of the property (excluding the value of land) each year. Residential rentals are depreciated over 27.5 years and commercial property over 39 years. Long-term improvements are also depreciable.
Mortgage interest is another valuable deduction, and unlike limits for personal-use property, you can deduct mortgage interest on every rental property you own. Additional expenses you can write off include insurance, property taxes, utilities you provide, gardening, and all maintenance and repairs. You can even write off the cost of advertising to attract tenants. These expenses are deductible even if the property is vacant, as long as you are actively looking for tenants.
Passive Loss Limits
This can be a big disadvantage if you're in a high tax bracket or have significant losses. Unless you're actively participating in your rental business, the IRS limits your real estate or "passive" losses to a maximum of $25,000 per return. However, there is no limit on losses if more than half of the hours you work during a year are in rental real-estate management and you spend more than 750 hours per year at it. Watch out here, because if the property is owned by a partnership the IRS will consider it passive income, no matter how active you are in the business.
If you sell rental property, you'll pay tax on any capital gain realized. For property owned more than a year, you'll pay the lower long-term capital gain rate. The possible downside here is that accrued depreciation must be subtracted from the purchase price, also called basis, of the property, translating into a higher capital gain on the final sale.
The disadvantage of all the rent you'll collect is that rental income may push you into a higher tax bracket. Several tax breaks including individual retirement account (IRA) deductions, passive loss write-offs, and dependent care credits are phased out with higher adjusted gross income. Also, you may find that you no longer qualify for certain deductions on your personal tax return.
Naomi Smith has been writing full-time since 2009, following a career in finance. Her fiction has been published by Loose Id and Dreamspinner Press, among others. She holds a Master of Science in financial economics from the London School of Economics and a Bachelor of Arts in political economy from the University of California, Berkeley.