Are you considering investing in a rental property? Or do you have a vacation home that you are thinking of renting out to others? If you are willing to be a bit more “hands-on” with your investment than you would with traditional financial instruments like stocks and bonds, owning a rental property can be a great source of supplemental income. Rental properties not only offer the potential for greater returns, but they also grant unique opportunities to lower your tax bill.

Offsetting Rental Income with Deductions

As is the case with any business, you can deduct any expenses that are considered ordinary and necessary for operating your rental property. Most allowable deductions are common expenses you’re likely already tracking – advertising, utilities, professional fees, etc. Some, however, are not so obvious. Mortgage interest, property management fees, and even travel are all deductible. As long as the travel is mainly for a business purpose such as performing a routine check-up on the property, any mileage, meals, hotel bills, etc., it can be taken as deductions.

Keep in mind that any income or losses generated from a rental activity will most likely be considered passive, unless you meet certain exceptions. This is particularly significant in the treatment of losses, as passive losses can only be used to reduce other passive income. Any disallowed passive losses are “suspended” and can be used in future years against passive income; suspended losses can also be taken as a deduction when the property is sold.

Special Note on Repairs vs. Improvements

Rental properties will inevitably require some sort of repairs. This could be anything from freshening up an old coat of paint to fixing a broken heater, or even adding an entirely new unit. When it comes to tax, these expenses may be treated differently depending on whether they are considered a repair or an improvement – a distinction that is not always clear. A paint job, for instance, is typically classified as an expense, but if it is part of a larger project, it may be considered an improvement. The IRS generally classifies an expense as an improvement if it falls into one of the following three categories:

  • Betterment: Makes a long-term asset better than it was before
  • Adaption: Adapts it to a new use, or
  • Restoration: Restores it to operating condition

Repairs in a rental property are usually preferable to improvements since you can immediately take them as deductions. Improvements are required to be capitalized and depreciated over their useful life and, depending on the asset, this could be over as many as 27.5 years. Capitalized improvements  increase your basis in the property, so you can enjoy the benefit of reduced capital gains later on (assuming the property is sold at a gain).

Beware of Depreciation Recapture

Of all the deductions that can be taken for a rental property, depreciation is one of the most significant in that it is both highly accessible (the building itself, appliances, furniture, etc. can usually all be depreciated) and generally substantial in the amount. While depreciation expense can provide meaningful tax savings, there is one drawback: depreciation recapture.

Normally, when you sell a capital asset held for longer than a year at a gain, the entire gain is taxed at the more preferential capital gain rates (0%, 15%, or 20%). However, when it comes to any capital assets for which you took tax deductions for depreciation expense, the portion of the gain that relates to depreciation is taxed at ordinary income rates (capped at 25%). Real property (e.g. the building) is only subject to recapture on “excess” depreciation picked up through accelerated depreciation methods. For this reason, straight-line depreciation is commonly used for real property as this precludes from recapture for that property.

Like-Kind Exchanges

Selling a rental property has the potential to incur a significant tax liability. One way to defer both capital gains tax and avoid ordinary recapture is to utilize a like-kind exchange. Put simply, a like-kind exchange (also called a 1031 exchange) is when you sell a property and replace it with another (both must be real property — a rental home, commercial office building, farmland, etc.). Assuming you have a legitimate like-kind exchange with each transaction, this can actually be done in perpetuity. As an added bonus, under current tax law, if the investor passes away, his or her heirs will receive a “stepped-up basis” on the property – effectively wiping out any depreciation recapture.

So what’s the catch? There are stringent requirements to qualify a transaction as a like-kind exchange. Some of these include:

• The replacement property needs to be identified within 45 days and purchased in 180 days.

• The new property must have equal or greater worth (fair market value) than the property sold.

• An intermediary must hold all cash from the sale up until the point it is used to buy the new property.

There are even more rules and regulations associated with a 1031 exchange, and a single misstep could trigger the capital gains tax you were originally hoping to avoid. If you have any interest in making a like-kind exchange, it is imperative to consult with your tax advisor to ensure you take all the right steps.

Homeowner’s Exclusion on Capital Gains

If you don’t want to go through the hassle of locating another property for an exchange, there is another possibility for reducing some of the capital gains taxes on the sale of the property. The IRS provides an exclusion of up to $500,000 for married couples or $250,000 for single taxpayers on capital gains associated with the sale of a home. While this exclusion was mainly designed for the sale of a taxpayer’s primary home, it can also be applied to a vacation or rental property that was converted into your primary residence. There are two basic requirements to meeting the IRS’ definition of  “primary residence:”

  1. The homeowner(s) must own the property for at least five years, and
  2. Use the property as a primary residence for at least 2 of the past 5 years.

There are two caveats. First, the homeowner’s exclusion does not apply to gains associated with depreciation recapture. Second, the amount of gain available to be excluded is reduced by the portion associated with the period of nonqualified use. For example, if an individual rented out their vacation home for three years and then moved in and resided there for two years, only 2/5 of the capital gain realized on the sale of the home will be eligible for exclusion.

Conclusion

Operating even a single rental property requires more work than a traditional investment, but the potential rewards can more than make up for it. Whether you’re doing your own bookkeeping, using a rental property manager, or otherwise outsourcing your accounting, be sure that you are maintaining thorough records. Be sure to consult your tax advisor before attempting to take advantage of any of the gain exclusion methods mentioned. These may not always be practical or advantageous, and even if they are, navigating all the rules and regulations will require guidance.