The Basics of Rental Property Taxation

[Music] hi i'm andy panko owner of tenon financial welcome to retirement planning demystified owning rental properties can provide a good source of income in retirement but the tax implication of rentals can get pretty complicated while it's impossible to cover all the rental tax angles in one video this video will at least discuss the basics of rental property taxation and be sure to like this video subscribe to this channel so you can be notified when i release additional videos some of which will be extra content about rentals but before we start remember this video is only general explanations and education it's not specific tax legal or investment advice before considering acting on anything you see in this video first consult with your tax legal or investment advisor to try to tie everything together i'm going to use the same example throughout this video it's going to be a house that you buy specifically to use as a rental and you eventually sell it after years of renting it out the accounting and taxation of this situation is relatively straightforward if you instead have a primary residence that you turn into a rental or vice versa or have a property that you use for part of the year as a rental and part of the year's vacation home that's when things get tricky those scenarios are beyond the scope of this video the benefit of owning a rental property is that it produces income but like most forms of income you have to pay tax on it however when you have a rental property it's an investment and there are costs and expenses associated with operating and maintaining that investment thankfully the irs lets you deduct most of the costs and expenses related to your rental such that you only have to pay tax on the net income or the amount of income left after subtracting out your expenses here are the most common deductible rental expenses advertising costs can be deducted like if you pay money to run an ad in the local newspaper to make it known that your property is available for rent certain auto and travel expenses can be deducted for example if you need to drive to the property to pick up a rent check that mileage driven can be deducted now i won't get into the specifics of deducting auto usage in this video but generally speaking there is a certain amount of cents per mile that the irs lets you deduct as rental related automobile expenses cleaning and maintenance expenses are deductible like if you are in between tenants and have to pay to have a service come in to shampoo the rugs scrub the kitchen and bathrooms and so forth related commissions are deductible such as if you use a broker to help you find a tenant and that broker charges you a fee or commission depreciation is also deductible i'll talk more about that in a bit depreciation definitely warrants its own discussion as it's a bit hard to grasp especially if you've never been involved in business or rental taxation before if your rental property is a condominium or other centrally managed structure where you have to pay homeowners association fees those fees are deductible your property insurance on the rental is deductible as is whatever bank interest you pay like when you have a mortgage on the property legal fees can be deducted as well for example if a tenant stops paying rent and you have to engage your lawyer services to help seek damages or potentially evict the tenant those legal fees are deductible if you use a property management service to do the maintenance tenant screening and so forth those fees are deductible mortgage points are also deductible points are basically just an additional upfront lump sum of interest you pay at the inception of a mortgage many mortgages don't have points but some do if you took out a mortgage to buy the property and you had to pay points on that mortgage that's deductible the cost of any repairs you have to make to the property or deductible but keep in mind this is just for repairs and not improvements repairs are things like fixing a leaky faucet replacing a torn screen in the screen door patching some holes in the walls and things like that they just fix the property to bring it back to its usable state but they don't improve or add additional usableness or value to the property improvements on the other hand are things like adding an extension putting on a deck gutting and renovating the kitchen and things like that those are things that add real function or value to the property that weren't already there improvements aren't deductible instead they add to the cost or basis of the property i'll touch on basis in a bit but for now know that if you spend one hundred dollars fixing a broken thermostat you can deduct that hundred dollars in the year of the repair but if you spend ten thousand dollars to renovate a bathroom that's an improvement not a repair and you can't deduct the whole ten thousand dollars in that year next are taxes you can also deduct taxes such as property or sewer taxes paid during the year and finally you can also deduct whatever utilities you have to pay for the property let's not talk about basis which i touched on before in taxpeak basis is basically just the cost you pay for something let's take a look at an example assume you purchased a rental property for three hundred fifty thousand dollars that's part of your cost or basis but you can also include in your basis certain settlement or other costs that were part of the closing process when you bought the property for example you can include in basis any legal fees recording fees transfer taxes and title insurance let's assume all those closing costs total ten thousand dollars add that to the property's 350 000 purchase price and your total basis is three hundred sixty thousand dollars while not shown here any improvements you make to the property will add to your basis remember the example i mentioned before of renovating the bathroom for ten thousand dollars well that wouldn't be a deductible repair expense instead it's an improvement to the property and improvements add to the basis so in this case the ten thousand dollar renovation would mean your basis in the property would actually be three hundred seventy thousand dollars not three hundred sixty thousand dollars all right let's not talk about depreciation first what is it well depreciation is the reduction in an asset's value over time due to its use wear and tear most physical things like buildings have a useful life over time they degrade break lose function etc that's what it means to depreciate it's important to know that land is assumed to not depreciate because land is land it's really nothing more than a plot of dirt some grass maybe some trees and so forth as such it doesn't really lose value or function over time with that said when you buy a house you're really buying both the building itself and the land that building is on the building would appreciate but the land will not for residential real estate it's assumed the depreciable life is 27 and a half years that means over the course of 27.5 years the building on the land is assumed to deplete of its usable life or at least that's the assumption from a tax perspective practically speaking most buildings stay standing much longer than 27.5 years but from a tax point of view the value of that building reduces linearly down to zero over the course of the twenty seven and a half years and during each year of those twenty seven and a half the amount of depreciation on your rental property can be deducted as an expense as i mentioned before the other thing to know about depreciation is that it's a non-cash expense for all the other expenses i mentioned before you have to actually pay something to get the deductions like if you have to pay 100 for an electric bill for your property that's 100 coming out of your pocket but the upside is you can at least reduce the amount of your rental income that's taxable by that hundred dollars with a non-cash expense like depreciation you still get to deduct it from your taxable rental income just the same however you don't actually have to pay anything out of pocket for that expense which is what i mean when i say it's a non-cash expense sounds great right you get a tax break for something that didn't actually cost you anything out of pocket many people get caught up in thinking these depreciation deductions are some kind of magical tax gift or freebie that comes along with owning rentals but not so fast while you can get the deducted non-cash depreciation expenses along the way you eventually have to pay the piper when you sell the place then you won't think depreciation is so great anymore i'll touch more on that in a bit let's take a look at an example of depreciation on your sample property we know the original basis was 360 thousand dollars but remember that land can't be depreciated so you have to figure out how much of your total purchase was attributable to the building itself versus the land well after looking at recent tax records assume that the town assessed the land at about 28 of the total property value that means that about 28 of your price or about 100 000 is considered the value of the land since you can't appreciate land you can only depreciate the remaining 260 thousand dollars and recall i said the irs treats residential real estate as depreciating over 27.5 years that means if you divide the 260 000 depreciable basis of the property by 27 and a half years you get an annual depreciation expense of 9 455 this is how much you'll be able to deduct in depreciation expense each year let's now take a quick look at how all this actually looks on your tax return here's a schedule e which is the form used to report most forms of rental income and expenses now i say most forms because there are some times where rental real estate activity gets reported on schedule c which is for self-employment income if you're actively engaged in the profession of buying and renting out properties and spend most of your time along with it then you may actually be quote unquote in the business of renting properties but in most cases you're likely just passively renting it in which case it goes on schedule e schedule e is fairly straightforward it lists the property address what type of property it is such as single family multi-family commercial and so forth how many days you rented it versus used it for personal use and it shows your total rent received in this example i'm assuming it was rented for 11 months at 3 000 per month so you had total rental income of 33 000 and then here all the deductible expenses for the year and here's the 9 455 of annual depreciation expense in this example i'm assuming you put the place up for rent to january 1st but you didn't actually have a tenant in there until february 1st hence you received only 11 months of rent for the year but just because you didn't have a tenant in there for all 12 months doesn't mean you can't deduct the expenses including appreciation for the whole year so long as the place was available to be rented put out to the world that it was for rent and ready and able to receive a tenant it was what's known as in-service and expenses are deductible so long as the property is in service anyway all said and done you had total expenses of twenty four thousand four hundred five dollars for the year and your gross income was thirty three thousand dollars but after deducting all your expenses from your gross income your net taxable income was only seven thousand five hundred ninety five dollars that's not bad especially since over nine thousand dollars of those deductible expenses were from depreciation which wasn't an actual cash outlay for you but again depreciation deductions aren't as much of a gift as they may appear you'll see what i mean in a little bit in this example you had a positive amount of net income from your rental that's seven plus thousand dollars of net income is simply added to the rest of your income for that year on your tax return and taxed accordingly what if you actually had a net loss for the year on your rental then things can get a bit tricky the full details of this is also something that's outside the scope of this introductory video but in a nutshell depending how much other income you have you may be able to deduct that loss against the rest of your income or if the rest of your income is too high you won't be able to deduct that net loss that year instead it carries over to future years such that if and when you have net positive amounts of rental income in future years the carried over losses will then offset and reduce those future positive amounts okay let's now look at what happens when you eventually sell the property specifically we'll assume you owned it as a rental for 10 years and then you sell it the key thing is that you owned it for more than 12 months this is important because gains you have on it will be taxed at a reduced long-term capital gains tax rate as opposed to your ordinary income tax rates which would be the case if you sold it within a year of when you bought it anyway assume it's ten years after you bought it and you sell it for four hundred thousand dollars and your adjusted basis at that time is two hundred ninety thousand four hundred fifty dollars that means your taxable gain in the sale is 109 thousand five hundred fifty dollars let's back that up a second because we have to dig into where the adjusted basis came from recall that your original basis in the property was three hundred sixty thousand dollars that was the original three hundred fifty thousand 000 purchase price plus the 10 000 of closing costs that were able to be included in the basis for this purpose we're not including the 10 000 bathroom renovation we'll assume that didn't happen and then as part of your sale there are similarly going to be closing costs that can essentially be treated as additional costs or basis in the property these are things like the real estate agent commissions legal fees and realty transfer taxes i'm assuming there was a total of twenty five thousand dollars with such other costs and now here's where all that depreciation you expense throughout the years comes back to bite you over the course of the ten years you own the rental property you deducted nine thousand four hundred fifty five dollars of depreciation per year that means in total you deducted ninety four thousand five hundred fifty dollars of depreciation over 10 years your adjusted basis is your original basis plus the certain closing costs from the sale minus the depreciation expensed over the years remember i said those depreciation deductions aren't as much of a gift as they appear you didn't get those tax deductions along the way for free they all decreased your basis or original cost and you pay for that when you eventually sell the place and here's how so you see the taxable gain in this case is one hundred nine thousand five hundred fifty dollars and remember i said long term capital gains are taxed at reduced tax rates well that's true but the amount of the gain attributable to the depreciation is not considered a capital gain and said the amount attributable to the depreciation is taxed higher specifically the amount of the gain attributable to depreciation is taxed at your ordinary income tax rates but only up to 25 percent it's only the rest of the gain that's taxable at the reduced long-term capital gains tax rates of either zero 15 percent or 20 percent in our case as you can see the majority of the nearly one hundred and ten thousand dollar taxable gain on the sale of your rental is due to having to recapture all the depreciation deductions you took along the way this is what i meant before when i said you'll eventually have to pay the piper in this case only a fairly small portion of your gain will be taxed at the reduced long-term capital gains tax rates so you may be thinking why can't i just not claim any of the depreciation deductions along the way and avoid the depreciation recapture when i eventually sell the place well the irs is already one step ahead of you on that because the amount of depreciation they make you recapture is the amount of depreciation that was allowed or allowable throughout the years that means that even if you didn't take the deductions for depreciation along the way you still have to pretend like you did when you sell the place therefore there really isn't a reason for you to not take the depreciation deductions year by year just know that you're going to have to give all those tax savings back when you sell the property now it may actually be a bit more complicated than that because if you end up selling a property at a loss then you don't have to recapture all the depreciation upon the sale that's another wrinkle that's outside the scope of this introductory video well that's it i hope you found this video helpful i know you're probably walking away from this with more questions than answers as i mentioned before the taxation of rental properties can get real complicated real quick this video shows only the most plain vanilla of examples and scenarios for more information check out irs publication 527 aptly titled residential rental property that will have lots more detail not addressed in this video be sure to subscribe to this channel so you can be notified when i release additional videos some of which will be more content about rental properties also subscribe to my monthly newsletter retirement planning insights which provides informative retirement planning tips and info and be sure to join my free facebook group taxes and retirement where you can learn all about tax efficient retirement planning thanks for watching i'll see you soon [Music]

Channel: Retirement Planning Education

Views: 88,131

Keywords: Retirement Income Planning, Rental Property, Rental Property Taxes, Retirement Planning, Tax Planning, Depreciation, Rental

Id: UuaSwQXrfQg

Length: 15min 45sec (945 seconds)

Published: Wed Mar 24 2021