A Tax Review for the Nonprofessional Landlord.
Renting Residential Real Estate. Investing in residential rental properties raises various tax issues that can be somewhat confusing, especially if you are not a real estate professional. Some of the more important issues rental property investors will want to be aware of are discussed below.
Currently, the owner of a residential rental property may depreciate the building over a 27½-year period. For example, a property acquired for $200,000 could generate a depreciation deduction of as much as $7,273 per year. Additional depreciation deductions may be available for furnishings provided with the rental property. When large depreciation deductions are added to other rental expenses, it's not uncommon for a rental activity to generate a tax loss. The question then becomes whether that loss is deductible.
$25,000 Loss Limitation
The tax law generally treats real estate rental losses as "passive" and therefore available only for offsetting any passive income an individual taxpayer may have. However, a limited exception is available where an individual owns at least a 10% ownership interest in the property and "actively participates" in the rental activity. In this situation, up to $25,000 of passive rental losses may be used to offset nonpassive income, such as wages from a job. (The $25,000 loss allowance phases out with modified adjusted gross income between $100,000 and $150,000.) Passive activity losses that are not currently deductible are carried forward to future tax years.
What constitutes active participation? The IRS describes it as "participating in making management decisions or arranging for others to provide services (such as repairs) in a significant and bona fide sense." Examples provided by the IRS of management decisions include approving tenants and deciding on rental terms.
Selling the Property
Gain realized on the sale of residential rental property held for investment is generally taxed as capital gain. If the gain is long term, it is taxed at a favorable capital gains rate. However, the IRS requires that any allowable depreciation be "recaptured" and taxed at a 25% maximum rate rather than the 15% (or 20%) long-term capital gains rate that generally applies.
Exclusion of Gain
The tax law has a generous exclusion for gain from the sale of a principal residence. Generally, taxpayers may exclude up to $250,000 ($500,000 for certain joint filers) of their gain, provided they have owned and used the property as a principal residence for two out of the five years preceding the sale.
After the exclusion was enacted, some landlords moved into their properties and established the properties as their principal residences to make use of the home sale exclusion. However, Congress subsequently changed the rules for sales completed after 2008. Under the current rules, gain will be taxable to the extent the property was not used as the taxpayer's principal residence after 2008.
This rule can be a trap for the unwary. For example, a couple might buy a vacation home and rent the property out to help finance the purchase. Later, upon retirement, the couple may turn the vacation home into their principal residence. If the home is subsequently sold, all or part of any gain on the sale could be taxable under the above-described rule.
16 Corporations: Calendar-year corporations file 2014 tax return (Form 1120) and pay any tax due. S corporations file Form 1120S. For an automatic six-month filing extension, file Form 7004 and deposit the estimated tax due.
31 Employers: Electronic filers must file 2014 Forms W-2 with the Social Security Administration.
15 Individuals: File 2014 income-tax return (Form 1040, 1040A, or 1040EZ) with the IRS. For an automatic six-month extension, file Form 4868 and pay the estimated tax due.
15 Individuals: Pay the first installment of 2015 estimated tax.
15 Partnerships: File 2014 calendar-year partnership return (Form 1065). For an automatic five-month extension, file Form 7004.
15 Corporations: Deposit first installment of 2015 estimated tax.
30 Employers: File Form 941, Employer's Quarterly Federal Tax Return; quarterly deposit due for those who meet the safe harbor requirements.
11 Employers: Deferred due date for Form 941, if timely deposits were made.
15 Exempt Organizations: File 2014 Form 990, 990-EZ, or 990-N, if the organization reports on a calendar-year basis.