Owning rental real estate is one of the most popular means by which Americans accumulate wealth. Given rising property values and the reliable cash flows rental properties offer, it’s no wonder that rental real estate is an attractive means to increase net worth.
Rental property owners should know the range of tax opportunities at their disposal, as the Internal Revenue Code treats rental properties differently—more favorably—than personal homes. Rental property owners may take more tax deductions than primary residence owners, and should leverage the power of allowable deductions not subject to the same limitations as personal properties. Knowing differences between rental and personal real estate regulations will allow rental property owners to avoid overpaying income tax.
Deductions
Mortgage Interest
Interest paid on a mortgage used to purchase a rental property is fully deductible, no matter the size of the mortgage. Contrast this with the limited deductions on mortgage interest primary residence owners claim on their returns. This provides a significant benefit to rental property owners, who can deduct every dollar spent on mortgage interest against the rental income the property generates.
Real Estate Taxes
Like mortgage interest, rental property owners may deduct 100% of real estate taxes paid on rental properties. State and local real estate taxes paid on a personal property, meanwhile, are subject to a $10,000 limitation.
Depreciation and Improvement Expenses
Perhaps the most attractive advantage that rental properties have over personal properties is the allowance of depreciation. Rental property owners can depreciate the value of rental properties over 27.5 years, along with any improvements made to the property. Importantly, this deduction allows a taxpayer to reduce taxable income with no related cash expenditure.
Repairs and Maintenance
Rental property owners can deduct maintenance expenses on rental properties on their tax return. These expenses are smaller in nature and are distinct from the significant repairs or improvements outlined above. The IRS has issued guidance distinguishing repair expenses from property improvements. See more details in IRS Publication 527.
Limitation on Losses
Rental property owners should correctly calculate the degree to which deductions are fully deductible. During years in which rental property owners incur more deductions than rental income (i.e., realize a taxable loss), any losses will be limited based on the level of involvement the property owner has in running rental activities. There are three levels of participation: material, active, and passive.
Material Participation
Material participation is the highest level at which an individual can participate in running rental activity. Based on IRS criteria, a taxpayer materially participates if they satisfy any of the following tests:
- They participate in the activity for over 500 hours during the year.
- They do nearly all work in the activity.
- They work over 100 hours in the activity and work at least as much as anyone else in the activity.
- They materially participated in the activity for any five of the past ten years.
- They participated in the activity on a regular, continuous, and substantial basis throughout the year.
If the property owner meets any of these criteria, a taxable loss will be fully deductible in the year incurred. For more information on material participation rules, see IRS Publication 925.
Active Participation
Active participation is a lower level of involvement than material participation. A rental property owner actively participates if they make management decisions for the activity but do not meet the criteria for material participation.
Taxpayers can deduct up to $25,000 of losses if their modified adjusted gross income (MAGI) is $100,000 or less. The deduction phases out for rental property owners whose MAGI is greater than $100,000; these deductions are fully suspended for property owners whose MAGI exceeds $150,000. Any losses not currently deductible can be carried forward to offset future rental income.
Passive Activity
A taxpayer will be treated as having a passive activity if they do not meet the tests for material or active participation. For rental property owners with passive interest in rental activities, taxable losses are limited to offsetting other current-year passive income. Any passive losses not currently deductible are carried forward indefinitely until future passive income is earned or when rental activity is disposed.
Important Takeaways
Taxpayers looking to grow their wealth and increase cash flow via rental properties should leverage the additional tax benefits that come with rental activity. Correctly calculating depreciation and other allowable deductions may allow rental property owners to claim zero taxable income.
It is important to understand all implications of rental property ownership on each taxpayer’s unique situation. Consult your tax advisor to guide you through this process.
