Rental Property Taxes
Many San Diego taxpayers find the idea of owning rental property appealing and rewarding. What could be better than enjoying tax breaks while tenants buy your property for you? Unfortunately, there is much more to real estate investing than just that. Success takes careful planning and a share of good luck – or being in a position to take advantage of (good luck) opportunities.
The monetary rewards from real estate investments come in three ways – monthly cash flow, tax benefits, and appreciation of the property. In San Diego, property appreciation has been significant. That is a nice bonus on top of the available tax benefits.
CASH FLOW
Cash flow is the difference between the rental income you receive and your total monthly expenses related to that rental property, such as mortgage payment, real estate taxes, insurance, and maintenance. Each rental property is different and will accordingly have different outcomes. Some properties show only a small positive cash flow or possibly a monthly loss of income (negative cash flow).
When considering your anticipated cash flow, remember to account for vacancies, when you’ll receive no rental income. There will also be unexpected repairs, such as plumbing or electrical issues, a leaky roof or a new HVAC unit. Make sure you have the cash reserves to withstand such inevitabilities.
TAX BENEFITS
With consideration to tax planning and preparation, there are a several tax benefits to owning rental real estate that you can take advantage of. You can “leverage” into a rental property and get tax-deferred appreciation on your rental investment. As the owner, one can withdraw funds from an appreciated property (through refinancing) without paying income tax on the proceeds at that time.
Investors can trade up to a larger real estate investment with a tax-deferred 1031 exchange. These tax benefits and opportunities are available to all taxpayers, not just a privileged few. However, before you purchase your investment, it is important to consult with a tax professional to review the fundamental tax rules on rental real estate.
DEDUCTIBLE EXPENSES
Rental property tax law allows you to deduct virtually all of your expenses related to that rental property from rental income, including mortgage interest, real estate taxes, insurance, and repairs.
Depreciation also offers a substantial tax benefit. Depreciation is a deduction which doesn’t require an outlay of cash like other expenses. Deducting depreciation often yields a net tax loss on paper from your rental investment, but not necessarily an actual cash loss. You can deduct depreciation over a period of years on buildings and improvements. However, land cannot be depreciated so the value for the land and structures has to be allocated appropriately for your depreciation calculations.
When the time comes for tax preparation, we at San Diego Tax Professionals will closely review all aspects of rental property including your rental income, expenses, and depreciation, as well as your overall income tax return as whole to maximize all tax benefits available to you.
RENTAL LOSSES
Real estate professionals have different tax rules for how income and losses are treated. However, for most taxpayers, if there is a loss, you actively manage the property, and your adjusted gross income (AGI) does not exceed $100,000, the rental loss (up to a maximum of $25,000) may be deducted from other income including interest, dividends, and salary. There is a phase out between $100,000 and $150,000 AGI for the $25,000 allowable loss.
If you don’t meet the $25,000 allowable deduction requirements, your net losses are suspended and carried over until a year in which you meet the requirements for the deduction, or until you sell the rental property.
APPRECIATION IN VALUE
Historically, a great portion of the financial reward from real estate has come from the appreciation in value of the property. However, a property may not appreciate, or it may take many years to realize any substantial appreciation in value. While selecting rental property, look for undervalued property or property where relatively inexpensive improvements or repairs will add significant value.
When it comes time to sell your rental property, any profit is considered taxable capital gain. There’s one additional complication, the portion of the gain that represents prior depreciation is subject to special tax rules aka depreciation recapture tax, generally taxed at 25%.
If you sell the rental property at a loss, the loss is considered “ordinary,” which means you can deduct the entire amount, rather than being limited by the annual capital loss limitation. If you expect a loss, proper tax planning can help offset anticipated spikes in ordinary income.
1031 TAX-DEFERRED EXCHANGES
If you exchange your rental property for “like-kind” property in a 1031 “tax-deferred” exchange, as opposed to selling it, you can delay the tax on any capital gain until you sell the replacement property. An exchange can be a good way to trade up to a more valuable rental property without creating an immediate tax liability.
“1031 exchanges” have special rules that require a Qualified Intermediary and proper planning. Though 1031 exchanges require careful planning and professional assistance, they can result in significant tax savings.
MANAGING RENTAL PROPERTY
Before you invest, give fair consideration to the amount of work it will take to manage rental property. You can hire a management company, as there are many here in San Diego, but that will cut into your profits and may jeopardize your tax benefits. There is money to be made by selecting the right property at the right price in the right location, finding the right tenants, and optimizing your tax breaks, but don’t underestimate the effort involved and the things that can go sideways.
The information presented above is general in nature and for illustrative purposes only. The tax laws governing rental real estate are extensive, complex, and continually changing. Before you commit to any purchase, sale, or exchange, contact our office in San Diego for a complete tax analysis and to discuss any questions related to rental property tax planning and tax preparation services.
If you are looking to learn more about our services, call us at (619) 282-1040, or contact us.
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