Any rental property you own counts as income and impacts your tax returns, but there are several things you can do to minimize tax burdens. Taking full advantage of tax deductions to lower your adjusted gross income (AGI) is an essential part of protecting yourself from overpaying. Your AGI is determined by adding up all of your taxable income items and subtracting your eligible tax deductions for those items. Common deductions include retirement plan contributions, IRAs, and alimony payments. By lowering your AGI, you reduce your taxable income and in turn, your exposure to excessive taxes. Knowing the ins and outs of the tax code can help you to maximize your tax advantages and reduce or defer some of your taxes.
For owners of rental real estate, depreciation is an essential tax deduction that can dramatically reduce your AGI. By using depreciation, you can deduct a percentage of your basis on your rental property each year. Basis is the original cost of the property after it has been adjusted by several factors, including depreciation. Some costs that are included in determining your basis are any assumed debt from the seller, legal costs of acquiring the property, recording fees, survey costs, transfer taxes, and title insurance costs. Over time your basis can change; this is called adjusted basis and occurs as a result of improvements, maintenance, and repairs.
All businesses can depreciate assets that have a useful life span of more than a year. To claim the deduction, the item has to have a measurable life span, and this rule applies to real estate as well. All properties are different, so there is no one way to determine their life span. Because of this, the IRS has laid out guidelines to help owners figure out the amount they can deduct each year. For most rental real estate, the IRS currently has the useful life span set at 27.5 years. So, you can divide the basis of a property by 27.5 to determine its annual depreciation. It is also essential to consider that only the building is depreciable, not the land it sits on. The most common way of determining the value of the area is to have it assessed by a professional appraiser. With all the pieces in place, you can benefit from the depreciation of your rental property until you sell it or until you have depreciated the entire basis.
Similar to depreciation, you can also deduct rental losses on your property. The IRS rules on this are complex, but there are some exceptions for some rental property owners like small landlords. A rental loss occurs when all of the operating expenses on your rental property exceed the income generated from the annual rent. If you own multiple rental properties, the annual income and losses from the properties are combined to determine your income from rental activity in any given year. By using your deductions for depreciation, it is not uncommon to claim a loss on your rental real estate even when your income is exceeding your expenses.
When it comes time to sell the property, you will have to pay tax on the gain you would have had, in addition to the depreciation deductions you took. The IRS requires that you adjust your basis by your depreciation deductions; therefore, your profit when you sell will be equal to your selling price minus your adjusted basis. However, even if your depreciation deductions are only pushing your tax liability off into the future, it is still a good thing. This is because, in the meantime, the money can be working for you in other investments and ventures. Plus, you can time the sale of a property to offset other losses or to fall in a year where your income puts you in a more favorable tax bracket.
DISCLAIMER: The author of this blog article and SVN Miller Commercial Real Estate do not offer legally binding tax advice. We recommend that rental real estate owners and other readers involved in the topics discussed in this blog article discuss their personal tax situation’s with a licensed finance professional such as a CPA or tax accountant.