"Are there tax advantages to owning rental properties?"
We will probably do an entire podcast episode on this topic. To hit some of the high notes on this, lots of people are diving into the rental market now. Real estate across the country is currently doing great. Interest rates are low, which has people wanting to buy more houses. A lot of people like real estate as an investment versus the stock market because of the tangible nature of it. With the stock market, people say they don't know why it goes up wind goes down, but they can look at a house, calculate the rent, and they feel better about their return.
Another point that makes rental property attractive is it's very easy to leverage debt into rental property. Someone can put a little money down, borrow the rest in the bank, and buy a rental property, and feel fairly secure about their investment.
Probably the biggest thing to note for someone first diving into real estate is that any loss generated from rental activity is going to be considers a passive loss. So if you make less than a $150,000 or you're a married couple make less than $150,000 a year, you can deduct up to $25,000 of those passive losses.
However, if you make more than that you can't deduct any of them. They carry forward against future passive earnings. A lot of people say, "why would I have passive losses, I'm collecting rent?" The main reason is because of depreciation. You're going to take the cost of the house and appreciate it over twenty seven and a half years and then add in any repairs you do to it or capital Improvements. A lot of those can be depreciated much faster. Even though you're collecting rent and the property is cash flowing, you may still have a lost on the tax return.
That's why it's important to talk to your accountant and look at your other income sources, what losses may be generated by the rental activity, and whether or not you're going to be able to deduct those losses. If you can't deduct the loss it doesn't mean that rental activities are not the right investment for you. It just means it may not be as attractive because those losses are going to carry forward to years where you do have the income.
You don't want to buy a rental property thinking it's going to get a lot of tax write-off, because depending on your other circumstances you may not.
Now one important point to talk about with rental activities is the classification of a real estate professional. The IRS says if you can classify yourself as a real estate professional then you're in the business of real estate. Those losses are no longer passive, they're active losses and you can deduct them. A good example is if you had a one income or one spouse is a high income earner and then another spouse that could manage the rental property and qualify as a real estate professional, then all the losses deducted by the rental activity could be deducted against the income of the spouse with the high-income job.
To be considered a real a professional you've got to spend 750 hours a year on your real estate activity and it has to be more than half your time. So if you don't have another job and you can show that you spent 750 hours a year, then you've passed the first step. However, if you've got a $2,000/year W-2 job somewhere else, you're going to have a real hard time proving that you spent more than 50% of your time on real estate because your burden of proof just went to 2001 hours.
If you pass that test, the second test you have to do is to show material participation in each one of your passive activities. If you've got 10 rent houses, you've got to prove that you materially participated in every single one of those rent houses. Now, one thing the IRS will allow you to do, and a lot of accountants miss this, is if you have rental properties and you are classifying yourself as a real estate professional, you need to have your accountant file what's called a nine election. That is an election with the IRS and it allows you to treat all your passive activities as one activity.
This is an area that the IRS likes to look into because if you classify yourself as a real estate professional then all of a sudden you're able to deduct all these passive losses that accumulate on this property. So it's very attractive for people to try to get that classification. It's important to document your time and have records to prove that you did spend the 750 hours and at least 50% of your time on the passive activities.
If you have any questions about your business, text them to me at 501-762-0116.