Residential Rental Tax Planning

 Residential Real Estate Tax Planning

Real estate investment is a very good investment and produce regular stream of income if managed properly as well creates equity for the future. If it is planned properly real estate investment can save a big deal of taxes if planned properly. Other investment has very little options when it comes to saving taxes, but real estate provides great deal of opportunities.

In most cases real estate rentals are passive income. However, there are certain tricks and tools that can help you save taxes not only for current year but also for future years. 

How is rental income taxed 

Rental income is a passive income in most cases, and it is taxes at the ordinary income tax rate. If there is loss, the loss can only be off set against passive income. If there is no passive income or passive income is not enough to offset rental income, the loss will be carried forward to future years until you have passive income. The passive income need not be from rental it can be from other passive activities also, like from passive partnership or any other business you invested in and did not participate actively.

What makes the income active or passive

If you materially participate in the activity you invested, that is active income. If you do not participate you are inactive/passive investor. The income or loss generated by your passive activity is passive income/loss.

What is material or active participation

You have material participation when you are involved in the activity on a regular, continuous and substantial basis. If you satisfy only one of the following seven rules, that constitutes material participation. But for limited partner rule is little different. In that case you need to satisfy rule number 1, 5 or 6.

 

1.      You participate in the activity for at least 500 hours during the year.

2.      Your participation is substantial than any other who is participating including non-owner

3.      You participate more than 100 hours and as much or more than any other person.

4.      The activity is a significant participation activity — that is, you participate more than 100 hours but you participated less than one or more other people yet your participation in all of your significant participation activities for the year totals more than 500 hours.

5.      You materially participated in the activity for any five of the preceding 10 tax years.

6.      In case of a personal service activity in which you materially participated in any three previous tax years.

7.      Regardless of the number of hours, based on all the facts and circumstances, you participate in the activity on a regular, continuous and substantial basis.

 

In nut shell you need to participate in the business substantially, that is it. If you are sole managing person of the business you are always active in your business.

 

However, In case of real estate, unless you are a real estate professional or your renting period per term is 7 days or less or you provide customer service(room service), your income will be active, and you may subject to self employment taxes. 

Rental Planning

Generally rental property produce book loss due to the depreciation and other expenses. In that case the rental loss as a passive loss cannot be offset against any other income and should be carry forward to future years. However, if you have income in the range of 100K to 150K, 25K of loss from rental can be offset against your other income for the year and balance will be carried forwarded. 

Here are few ways you can offset your rental loss with regular other income

7-days rule: If you rent your property for 7 days or less in average during the year, your loss from the property can be deducted from ordinary income. However, in case of profit you may end of paying self-employment taxes of 15.3% on top of your regular tax.

Short Term Rental with Room Service: If you provide room services or other substantial service to your renters that loss can be active loss and offset with other income. This is mostly applicable to Airbnb rental.

Setoff up to 25K 

If your earned income is less than 100K you can offset rental loss up to 25K. The offset phases out if you cross 100K and vanish on 150K of earned income.

Other Relevant Points

Deprecation 

You are allowed to take deprecation on the property you rented. The life of residential real estate is 27.5. The cost basis of the property is depreciated during 27.5 years. But land is not depreciated. You might need to apportion land cost and take depreciation only on the property. 

Cost segregation 

Residential real estate has 27.5 years of life for depreciation. However, if you do cost segregation you might be able to save great deal of tax by depreciating personal and other assets in the property. For example, carpet has life of 5 years, Cabinet may be 7 years, fence 15 years, and fridge/washer/dish-washer has life of 5-7 years and so on. With cost segregation you can take more depreciation and save taxes in initial years. Also the personal properties can be written off during the first year under Sec 179/Sec 168 at once.

 Rental Property Sell

 Claim loss at the sale of the property

If you dispose/sell the property entirely, the loss becomes active and you may be able to offset the loss with your other active income. The capital gain from the property should be first adjusted with the passive loss and remaining can be claimed. 

Sell property with gain and loss same year

Sell the property that has passive loss and sell it to save taxes. Also sell two properties one of which makes capital loss. That will offset your gain from the other property. 

Sec 1031 Exchange 

Go for sec 1031 exchange. This will defer your gain for the future if you invest all of the money you received from the property. IF you take out money, that is taxable. If you are planning give the property to your children on your death. The children do not have to pay tax when they sell it. The FMV basis rule gives zero tax to them.

Jyoti Raj Adhikari, CPA