Book: Every Landlord’s Tax Deduction Guide

“Every Landlord’s Tax Deduction Guide” by Stephen Fishman, J.D.

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“When you own residential rental property, you are required to pay the
following taxes:
• income taxes on rental income and property sales
• Social Security and Medicare taxes (for some landlords)
• net investment income taxes (for some landlords), and
• property taxes.”
“Profits from the sale of rental property owned for more than one year are taxed at capital gains rates. These rates are lower than income tax rates, except for taxpayers in the lowest tax brackets.”
“For more information (on Section 1031 exchange or tax-free exchange), see IRS Publication 544, Sales and Other Dispositions of Assets.”
“Everyone who works as an employee or who owns his or her own business
must pay Social Security and Medicare payroll taxes (known as FICA. or
Federal Insurance Contributions Act, taxes).”
“Social Security tax. The Social Security tax is a flat 12.4% tax on net
self-employment income or employee wages up to an annual ceiling, which
is adjusted for inflation each year.”
“Medicare payroll tax. There are two Medicare tax rates: a 2.9% tax up
to an annual ceiling—$200,000 for single taxpayers and $250,000 for
married couples filing jointly. All income above the ceiling is taxed at a
3.8% rate.”
“The income you earn from your rental property is not subject to
Social Security and Medicare taxes. (I.R.C. § 1402(a)(1).)”
“There is an important exception to the rule that landlords don’t have
to pay Social Security or Medicare taxes on their rental income. Namely,
this tax must be paid by landlords who provide “substantial services” to
their tenants. These are services provided for tenants’ convenience that
are typically provided by hotels or bed and breakfasts, such as maid
service, food, or concierge services. The value of such services must be
equal to at least 10% or 15% of the rent charged to be substantial. If you
provide substantial services to your tenants, your activity is classified as
a regular business, not a rental activity.”
“If you’re an individual owner, you report your income or losses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship).”
“If your rentals earn a profit and you expect to owe at least $1,000 in income
tax on the profit, you may need to pay estimated taxes to the IRS to prepay
your tax liability.”
“If you pay estimated tax, the payments are due four times per year:
April 15, June 15, September 15, and January 15.”
“For details, see the IRS estimated tax webpage at http://www.irs.gov/Businesses/Small-Businesses-Self-Employed/Estimated-Taxes.”
“You only pay tax on your net rental income each year—your total income minus your deductible expenses.”
“Security deposits. When you receive a security deposit that you plan to
use for the tenant’s final rent payment, you should include that amount
in your income for the year when you receive it. However, do not
include security deposit money in your income when you receive it if you
plan to return the money to your tenant at the end of the rental term.”
“Interest earned on security deposits is also rental income that should
be included in your income in the year it is earned, unless your state or
local law requires landlords to credit that interest to tenants.”
“Rental expenses paid for by tenant. Any rental expenses paid for by a
tenant are rental income; for example, payments a tenant makes to you
for repairs, utilities, or other rental costs. These costs are then deductible
by you as rental expenses.”
“Advance rent payments. Advance rent is any amount you receive before
the period that it covers. Include advance rent in your rental income in
the year you receive it, regardless of the period covered. For example, to
get you to agree to a one-year lease, a tenant with poor credit pays you
six months’ rent in advance in December. You must include the entire
amount as rental income in the year it was received.”
“Fees. Fees or other charges tenants pay are also rental income. These
include:
• fees you charge tenants for paying rent late
• garage or other parking fees
• fees you charge tenants for use of storage facilities, and
• laundry income from washers and dryers you provide for
tenants’ use.”
“Many landlords have so many deductions that they end up with a net
loss when they subtract all their deductions from their effective gross
rental income. In that situation, they owe no tax at all on their rental
income. This is especially common in the early years of owning rental
property when you haven’t had time to raise the rents much.”
“Landlords can deduct the following broad categories of rental expenses:
• start-up expenses
• operating expenses
• capital expenses, and
• pass-through tax deduction.”
“If your rental activity qualifies as a business, up to $5,000 of
start-up expenses may be deducted for the year in which they’re incurred. The remainder, if any, must be deducted in equal installments over the
first 180 months you’re in business—a process called amortization.”
“Operating expenses are the ongoing, day-to-day costs a landlord incurs
to operate a rental property. They include such things as mortgage
interest, utilities, salaries, supplies, travel expenses, car expenses, and
repairs and maintenance.”
“The cost of your capital assets must be deducted a little at a time over
several years—a process called depreciation. Residential rental buildings
(and building components) are depreciated over 27.5 years. The cost
of land is not deductible—you must wait until land is sold to recover
the cost. However, the cost of personal property used in your rental
activity—computers, for example—can usually be deducted in a single
year using 100% bonus depreciation or Section 179 of the tax code.”
“From 2018 through 2025, landlords may qualify for a special pass-through
tax deduction. This enables them to deduct from their income taxes up
to 20% of their net income from their rental activity.”
“The simplest way to own rental property is for a single individual to own
it in his or her own name. When you do this you are a sole proprietor for
tax purposes. Any rental income you earn is added to your other income,
such as salary from a job, interest income, or investment income. Losses
you incur can be deducted from your other income, subject to the
restrictions discussed in Chapter 16. You report your rental income and
losses on IRS Schedule E and attach it to your individual tax return.”
“Although the rental is held in your name
alone, unless you and your spouse agree otherwise, it will be jointly
owned community property under your state’s marital property laws.
However, for tax purposes, you may still treat the rental activity as a sole
proprietorship with only one spouse listed as owner on Schedule E.”
“Unlike in a partnership, a cotenant cannot act or contract on behalf of the other cotenants without their authorization. Moreover, one cotenant is not liable for any debts incurred by another cotenant without his or her consent. Each tenant in
common may lease, mortgage, sell, or otherwise transfer all or part of his
or her interest without obtaining consent from the other cotenants, or
even telling them about it.”
“If you are a partnership, here is what you’re supposed to do:
• complete and file Form 1065, U.S. Return of Partnership Income,
reporting all the partnership’s income, deductions, gains, and losses
• complete a Schedule K-1 for each partner showing his or her share
of the partnership’s income or loss
• transfer the Schedule K-1 information onto a Schedule E,
Supplemental Income and Loss, for each partner
• complete a Schedule SE for each partner, listing his or her share of
partnership income as self-employment income, and
• transfer the data from the individual schedules onto the joint
Form 1040.
Obviously, this requires a lot of time and money—tax pros can charge
$1,000 or more to prepare partnership returns.”
“Spouses who own rental property together typically take title as joint
tenants—rather than tenants in common.”
“Joint tenants must own the property 50-50. In
addition, joint tenancy always includes “the right of survivorship.”
When one joint tenant dies, his or her share automatically goes to the
survivor. This is not the case with tenants in common, who can leave
their share of the co-owned property to anyone they want. Unmarried
people can also be joint tenants, but this isn’t commonly done.”
“If a married couple that jointly owes rental property files a joint
income tax return, as most do, they are treated as a single taxpayer by
the IRS. The spouses’ shares of the income and deductions from the
rental property are combined on their single joint tax return. The couple
reports their income and deductions from the jointly owned property on
a single Schedule E they file with their joint return.”
“However, spouses who provide significant services to their tenants will be viewed as partners in a partnership by the IRS. (See ‘Co-owners who provide services to
tenants,’ above.) This means they would have to file a partnership tax
return—unless they can elect joint venture status.”
“To avoid having to file a partnership tax return, spouses who provide significant services to their tenants can elect to be taxed as a ‘qualified joint venture.’ When
this is done, both spouses are treated as sole proprietors of a Schedule C
business for tax purposes. They each file an IRS Schedule C, Profit or
Loss From Business (Sole Proprietorship), with their joint return.”
“The IRS regulations
discussed above make clear that it is not necessary if the spouses merely
maintain, repair, and rent out their property—this activity is not a partner-
ship for tax purposes.”
“There are some special rules for co-owner spouses who live in community property states. There are nine such states: Arizona, California, Idaho, Louisiana, Nevada,
New Mexico, Texas, Washington, and Wisconsin.
If you live in one of these states, you and your spouse will auto­matically
be co-owners of any rental property you acquire while you’re married,
unless you agree otherwise.”
“The IRS says that spouses in community property states may treat their
rental activity either as a sole proprietorship (technically, a “disregarded
entity”) or a partnership. Either one is fine. If sole proprietorship status is
selected, they would file one Schedule E and would not have to allocate
their rental income and expenses between themselves. All they need do
to elect this status is file their one Schedule E. They do not need to elect
qualified joint venture status to avoid having to file a partnership return.
(Rev. Proc. 2002-69 (10/9/2002).)”
“Partnerships, limited partnerships, LLCs, and S corporations are all
pass-through entities. A pass-through entity does not pay any taxes
itself. Instead, the business’s profits or losses are passed through to its
owners, who include them on their own personal tax returns (IRS Form
1040).”
“Partnerships and limited partnerships. These must file an annual tax form
with the IRS (Form 1065, U.S. Return of Partnership Income). Form 1065
is used to report partnership revenues, expenses, gains, and losses. The
partnership must also provide each partner with an IRS Schedule K-1,
Partner’s Share of Income, Deductions, Credits, etc., listing the partner’s
share of partnership income and expenses (copies of these schedules must
also be attached to IRS Form 1065). The partners must then file IRS
Schedule E, Supplemental Income and Loss, with their individual income
tax returns, showing the income or losses from all the partnershipsi n which they own an interest. Partners complete the second page of Schedule E, not the first page, which individuals use to report their income and deductions from rental property.”
“S corporations. These entities must file information returns with the
IRS on Form 1120-S, U.S. Income Tax Return for an S Corporation,
showing how much the business earned or lost and each shareholder’s
portion of the corporate income or loss.”
“LLCs. LLCs with only one member are ordinarily treated like a sole
proprietorship for tax purposes. The member reports profits, losses, and
deductions from rental activities on Schedule E. An LLC with two or
more members is treated like a partnership for tax purposes, except in
the unusual situation where the owners choose to have it treated like
a C or S corporation. However, an LLC owned by just one person is
treated as a “disregarded entity” for tax purposes. This means that the
single LLC owner is treated the same as a sole proprietor.”
“Landlords who own their properties through business entities don’t
use individual Schedule Es to report their rental income or losses. Instead,
the partnership, limited partnership, LLC, or S corporation files IRS
Form 8825, Rental Real Estate Income and Expenses of a Partnership or an
S Corporation, to report the income and deductions from the property
owned by the entity. This form is very similar to Schedule E.”
“Moreover, real estate professionals whose rental activities qualify as
a business can completely avoid the 3.8% Net Investment Income tax that went
into effect in 2013.”
“You can
far more effectively protect yourself from such lawsuits by obtaining
liability insurance for your rental property. The cost is a deductible rental
expense.”
“However, if you’re dead set on owning your rental property through
a business entity, the entity of choice is the LLC. It provides the same
degree of limited liability as a corporation, while also giving its owners
pass-through taxation—the most advantageous tax treatment for real
property. As a result, LLCs have become very popular among real
property owners in recent years.”
“So long as a real estate professional devotes a minimum
of 501 hours per year to the rental activity, it will automatically qualify
as a business and the rental income will not be subject to the NII tax.
Alternatively, if a real estate pro has participated in rental real estate
activities for more than 500 hours per year in five of the last ten tax years,
the rental activity will qualify as a business.”
“Most small landlords do not qualify as real estate professionals, thus the
regulation doesn’t directly apply to them. However, it does establish the
general principle that, as far as the IRS is concerned, anyone who works
at least 500 hours a year at a rental activity is engaged in a business for
tax purposes.”
“The IRS and court found that the house was an
investment, not a business for Grier. The court noted that this was the
only rental property Grier had ever owned and concluded that his landlord
activities were too minimal to rise to the level of a business. (Grier v. United
States, 120 F.Supp. 395 (D. Conn. 1954).)”
“Thus, both business owners and investors may deduct:
• repair costs (see Chapter 4)
• depreciation (see Chapter 5)
bonus depreciation (see Chapter 5)
interest (see Chapter 8)
taxes (see Chapter 15)
car and local travel expenses (see Chapter 11)
long-distance travel expenses (see Chapter 12)
meal and entertainment expenses (see Chapter 15)
the costs of hiring workers (see Chapter 13)
casualty losses (see Chapter 14)
payments for professional services (see Chapter 3), and
other operating expenses, such as advertising and insurance
(see Chapter 3).
And the requirements to qualify for these deductions are the same for
business owners and investors.”
“These business-only
deductions include:
• Net Investment Income tax. Rental income earned by a taxpayer
who qualifies as a real estate professional for tax purposes will not
be subject to the 3.8% Net Investment Income tax if the rental
activity qualifies as a business. If the activity is an investment, the
rental income will be subject to the tax even though the landlord
is a real estate professional.
• Pass-through income tax deduction. Investors can’t take advantage
of the pass-through tax deduction that enables business owners to
deduct up to 20% of their net business income from their income
taxes during 2018 through 2025. (See Chapter 7.)
• Home office deduction. Investors can’t take a home office deduction.
This important deduction is available only for businesses
conducted from home. (See Chapter 10.)
• Section 179 expensing. Investors cannot take advantage of Section
179, the tax code provision that allows businesspeople to deduct a
substantial amount in purchases of long-term personal property in
a single year. (See Chapter 5.)
• Seminar or convention deductions. Investors cannot deduct their
expenses for attending conventions, seminars, or similar events.
Thus, for example, the cost of attending a real estate investment
seminar is not deductible for investors. Businesspeople can qualify
for such deductions. (See Chapter 12.)
• Start-up expense deduction. Up to $5,000 of the costs you incur
to start your rental business may be deducted in the first year
your business is in operation. Any amount over the limit must be
deducted in equal installments over the first 180 months you’re
in business. (See Chapter 9 for more on deducting start-up costs.)
You get no deduction at all for expenses incurred in starting up an
investment activity.
• Real estate losses. If an investor loses money when he or she sells
real estate, the loss is a capital loss. Investors can deduct only
$3,000 in capital losses each year from their ordinary income—
that is, income not derived from capital assets like real estate,
stocks, bonds, and other investments. Business owners get much
better tax treatment when it comes to losses. Any gains they earn
when they sell real estate used in their business and held for more
than one year are taxed at capital gains rates—usually lower than
the normal income tax rates. But, if a business owner sells business
real property at a loss, the loss is deductible in full from all of
the owner’s income, not just income from capital assets. (I.R.C.
§ 1231.) Thus, when it comes to buying and selling real estate,
business owners have the best of both worlds—their gains are
taxed as capital gains, but their losses are treated as ordinary losses.
(See Chapter 16 for more on real estate losses.)”
“The TCJA completely removes the personal deduction for hobby expenses starting in 2018 through 2025. This means that while the income from a rental activity classified as a hobby must be reported and tax paid on it, no expenses may be deducted.”
“If you earn a profit from your rentals in three out of five consecutive years,
the IRS must presume that you have a profit motive.”
“Many of the most common types of
landlord operating expenses are listed on IRS Schedule E, including:
• advertising your rental units in newspapers or on the Internet
• auto and travel expenses incurred by you or your staff
• cleaning and maintenance
• commissions you pay to rental brokers, if you use them
• insurance, such as property and commercial general liability
insurance, and part of your automobile insurance if you use your
car for rental activities
• legal and other professional fees, such as accounting fees
• management fees, should you decide to hire a management
company to handle day-to-day operations
• mortgage interest paid to banks or other financial institutions
• other interest expenses, such as interest on a credit card you use to
buy items for your rental activity
• repairs
• supplies to clean and refurbish your rental property
• taxes, and
• utilities.”
“In addition to the items listed, you may also have deductible operating expenses for such things as office rent, equipment rental, publications and subscriptions
(including the cost of this book!), education expenses, postage, software,
payments to independent contractors, membership fees for landlord
associations, and so on.”
“Anything you purchase that will
benefit your rental activity for more than one year is a capital, not a
current, expense. For example, if a landlord purchases a lawn mower
to use for his rental properties, the purchase would be a capital expense
(not a current expense) because the lawn mower will benefit the rental
activity for more than one year. In some cases, capital expenses may only
be deducted a little at a time over many years through a process known as
depreciation. This is the case for rental buildings and other real property.
However, long-term personal property like a lawnmower can usually
be deducted in one year using 100% bonus depreciation, Section 179
expensing, or the de minimis safe harbor.”
“For example, replacing a few shingles on the roof of a rental
house is a repair that can be currently deducted. However, improvements
to real property that extend the property’s useful life or make it more
valuable must be depreciated. Thus, the cost of purchasing and installing
a whole new roof for a rental home would be a capital expense that would
have to be depreciated over several years.”
“If you buy something for both personal and landlord use, you can deduct
only the business portion of the expense. You must figure out how much
of the time you used the item for landlord purposes and how much for
personal purposes. You then allocate the total cost between the two
purposes, and deduct only the landlord portion of the cost.”
“Sheila owns a three-bedroom house that she uses as her
residence. She rents out one of the bedrooms, which represents 15% of the
total house. Sheila may deduct 15% of the cost of utilities and maintenance
for the whole house as a landlord operating expense. She could deduct
100% of the cost of any expense incurred just for the rented bedroom—for
example, the cost of repainting the bedroom.”
“A landlord may never deduct the value of his or her own time and personal
labor working on rental activities.”
“Landlords may deduct labor costs only when they hire other people
to do the work and pay them for it. The labor can be performed by an
employee or independent contractor (nonemployee), or even a member of
the landlord’s family.”
“Improvements to residential rental real property must be depreciated
over an especially long period—27.5 years.”
“In contrast, land improvements can usually be deducted in one year
using bonus depreciation during 2018 through 2025.”
“Improvements
to personal property used in your rental activity—for example, new
appliances or carpeting in rental units—can also usually be deducted
in one year using bonus depreciation, Section 179 expensing, or the
de minimis safe harbor.”
“The repair regulations are contained in Internal Revenue Bulletin
2013-43 (available at http://www.irs.gov/irb/2013-43_IRB/ar05.html; the IRS
has created a detailed set of FAQs about them at http://www.irs.gov/businesses/
small-businesses-self-employed/tangible-property-final-regulations).”
“First, determine whether the expense qualifies as a current
deduction under one of three new safe harbor tests.”
“Second, if none of the safe harbors apply, determine whether the ex-
pense is a deductible repair or improvement under the regular repair
versus improvement rules laid out in the IRS repair regulations.”
“Third, if you determine the expense is for an improvement, deter-
mine if the asset is real property (building or building component)
or personal property. If it’s personal property, determine if you can
deduct the expense in one year using the de minimis safe harbor,
bonus depreciation, or Section 179 expensing.”
“The SHST may be used only for
buildings—including condos and co-ops—with an unadjusted basis
of $1 million or less.”
“‘Unadjusted basis’ usually means a building’s original cost (also called its cost basis), not
including the cost of the land.”
“If you own more than one rental unit or building, the $1 million limit is applied to each separately.”
“A landlord may use the SHST only if the total
amount paid during the year for repairs, maintenance, improvements, and similar expenses for a building does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building.”
“Assume that one year Sonia spends $5,000 to repave
the parking lot of her apartment building and another $10,000 on maintenance and improvements for the building itself. She need not include the $5,000 when determining whether her building qualifies for the SHST because the parking lot is a land improvement she is depreciating separately from the building. As a result, her total
expenses for the year are $10,000—within the SHST annual limit.”
“Finally, to qualify for the SHST a landlord must
have average annual gross receipts of no more than $10 million during the three preceding tax years. Gross receipts include income from sales (unreduced by cost of goods), services, and investments. This poses no problem for smaller landlords.”
“Expenses that qualify as routine maintenance under this provision are deductible in a single year. Unlike with the safe harbor for small taxpayers, there are no annual dollar
limits with this safe harbor. Any landlord can use it, no matter the cost of the building involved, the amount of the landlord’s income, or the amount spent on the maintenance.”
“Routine maintenance includes two activities:
• inspection, cleaning, and testing of the building structure and/or
each building system, and
• replacement of damaged or worn parts with comparable and
commercially available replacement parts.
The first activity—inspection, cleaning, and testing of buildings and
building systems—is typically currently deductible in any event as an
ordinary and necessary business expense.”
“In determining whether you can reasonably expect to have to perform the maintenance more than once every ten years, you are supposed to take into consideration factors such as the recurring nature of the activity, industry practice, manufacturers’ recommendations, and your own experience with similar or identical property.”
“A nonexclusive list of examples of maintenance for rental properties
routinely performed more than once every ten years likely includes such
items as:
• inspecting, cleaning, and repairing HVAC units
• clearing and replacing rain gutters
• inspecting and replacing sprinklers
• smoke detector inspection and replacement
• lighting inspection and replacement
• paint touch-up
• chimney inspection and cleaning
• furnace inspection, cleaning, and repair, and
• inspecting and replacing washing machine hoses.”
“For example, the regulations provide that installation of
a new waterproof membrane (top layer) on a building’s roof to eliminate
leaks through an original (worn) membrane is a deductible repair.”
“Although not strictly required by the IRS, you may wish to create a written long-term maintenance plan for your rental property, showing when major maintenance needs to be performed on each building system. You don’t need to file the plan with your return. Just keep it in your tax files in the event of an IRS audit (or to show your tax pro who prepares your return).”
“Moreover, the maintenance must be attributable to the taxpayer’s use of the property, not that of a previous owner. Thus, the safe harbor does not apply to scheduled maintenance performed shortly after purchasing a building.”
“In addition, this safe harbor is not supposed to be used to currently deduct major remodeling or restoration projects. It specifically does not apply to expenses for betterments or restorations of buildings or other business property in a state of disrepair.”
“No amount is deductible under the small taxpayer safe harbor if the annual limit is exceeded. Thus, for example, if your annual SHST limit is $5,000 and you deduct $6,000 under the routine maintenance safe harbor, you won’t be entitled to any deduction under the small taxpayer safe harbor. But you can still use the routine maintenance safe harbor.”
“Unlike the safe harbor for small taxpayers discussed above, the routine maintenance safe harbor is not elective—that is, it is not claimed each year by filing an optional election with your tax return. Rather, the routine maintenance safe harbor is a method of accounting you adopt. Moreover, after you adopt it, you must use it every year.”
“The third safe harbor is the de minimis safe harbor (IRS Reg. §1.263(a)-1(f )). Landlords may use this safe harbor to currently deduct any low-cost items used in their rental business, regardless of whether or not the item would constitute a repair or an improvement under the regular repair regulations.”
“As with the routine maintenance safe harbor, all expenses you deduct using the de minimis safe harbor must be counted toward the annual limit for using the safe harbor for small taxpayers (the lesser of 2% of the rental’s cost or $10,000).”
“The structural components include a
building’s walls, partitions, floors, and ceilings, as well as any permanent coverings for them such as paneling or tiling; windows and doors; the roof, and other components relating to the operation or maintenance of the building.”
“Thus, if a landlord improves a rental building’s structural component— for example, by replacing the entire roof—the expense is treated as an improvement to the single UOP consisting of the building. On the other hand, a repair to a structural component—such as replacing a few roof shingles—may be currently deducted.”
“The following eight building systems are also considered separate UOPs under the IRS rules. The rules must be separately applied to each such system.

Heating, ventilation, and air conditioning (‘HVAC’) systems. This includes motors, compressors, boilers, furnaces, chillers, pipes, ducts, and radiators.

Plumbing systems. This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste.

Electrical systems. This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to distribute electricity.

Escalators.

Elevators.

Fire-protection and alarm systems. This includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and firefighting equipment, such as extinguishers and hoses.

Security systems. This includes window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring, and conduits.

Gas distribution system. This includes pipes and equipment used to distribute gas to and from the property line and between buildings.”
“If you own a condominium, the individual unit you own and the structural components are the UOP. Therefore, any improvements you make in your unit to any portion of the eight building systems defined above must be depreciated.”
“Landlord Bob purchases a new refrigerator, stove, and dishwasher for his single-family residence rental. Each appliance is its own UOP because placing one into service does not depend on the other. For example, the stove can be placed into service regardless of whether the refrigerator and dishwasher are available for use in the home.”
“The refrigerator Bob purchased includes a cooling mechanism, light, and ice-cube maker. Each of these components are functionally interdependent on each other and thus make up the single UOP consisting of the refrigerator.”
“If the answer to all three is ‘no,’ the expense is a repair. If the answer to any question is ‘yes,’ the expense is an improvement.

Does the expense add to the value of the UOP (betterment)?
Yes _ No _

Does the expense adapt the UOP to a new or different use
(adaptation)? Yes _ No _

Does the expense substantially prolong the useful life of the UOP
(restoration)? Yes _ No _“
“Repairs made before property is placed in service are not deductible. You are allowed to deduct the cost of repairs to a rental building only if they are made after it is placed in service in your rental activity—that is, after you have offered it for rent to the public. The cost of repairs you make before a building is in service must be added to its tax basis (cost) and depreciated along with the rest of the building. (IRS Reg. § 1.263(a)-2(d)(1).)”
“The only exception to this rule is where the repairs qualify as start-up expenses for a brand-new rental business. This is a limited deduction of up to $5,000 you may take for getting a new rental business up and going.”
“Maintenance is not the same thing as repairs. Maintenance is undertaken to prevent something from breaking down. A repair is done after a break-down has occurred. For example, the cost of oiling the circulator pump in a hot water heater is maintenance; the cost of fixing an unlubricated pump that has failed is a repair. There is no practical tax difference between maintenance and repairs—they are both currently deductible operating expenses. However, because IRS Schedule E requires that you separately list what you spent for each category, you must keep track of these expenditures separately.”
“An expenditure is for a betterment if it:
• ameliorates a “material condition or defect” in the UOP that existed before it was acquired
• is for a “material addition” to the UOP—for example, physically enlarges, expands, or extends it, or adds a new component
• is for a material increase in the capacity of the UOP, such as additional cubic or linear space, or
• is reasonably expected to materially increase the productivity, efficiency, strength, or quality of the UOP or its output (the productivity and output factors don’t usually apply to buildings). (IRS Reg. § 1.263(a)-3(j)(1).)”
“Fixing a material defect or condition that existed before you acquired the UOP is a betterment. Fixing conditions that occur after you acquire a UOP is not a betterment, but may be a restoration.”
Betterment: “Remediation of contaminated soil caused by leakage from underground gas storage tanks that were in place before landowner purchased the property (IRS Reg. § 1.263(a)-3(j)(3), Ex. 1.)”
Repair: “Replacing asbestos insulation in an old building that was constructed when dangers of asbestos were unknown and that began to deteriorate after building was purchased (IRS Reg. § 1.263(a)-3(j)(3), Ex. 2.)”
“An expenditure is for a restoration if you:
• replace a major component or a substantial structural part of a UOP
• rebuild the UOP to like-new condition after it has fallen into
disrepair
• replace a component of a UOP and deduct a loss for that component
(other than a casualty loss)
• replace a component of a UOP and realize gain or loss by selling or
exchanging the component
• restore damage to a UOP caused by a casualty event and make a
basis adjustment to the UOP (see Chapter 14), or
• rebuild a UOP to like-new condition after the end of its IRS class
life. (IRS Reg. § 1.263(a)-3(k).)”
“Replacing a major component or a substantial structural part of a UOP is a restoration
that must be depreciated.”
“Once you allow a unit of property to fall into disrepair—that is, it no longer performs its intended function—amounts you spend to get it working again are improvements.”
“A taxpayer allows a building he uses for storage to fall into
disrepair—that is, it could no longer be used because it was structurally
unsound. He pays a contractor to shore up the walls and replace the siding.
This expense constitutes a restoration that must be depreciated. (IRS Reg. §
1.263(a)-3(k)(7), Ex. 6.)”
“A disrepair restoration must be depreciated even if the expense would have qualified for the routine maintenance safe harbor if the UOP was not in a state of disrepair. The routine maintenance safe harbor cannot be used for UOPs in a state of disrepair.”
“For example, the class life for residential rental property is 40 years, while the class life for furniture and fixtures that are not a structural component of a building—such as refrigerators, stoves, countertops, carpets, kitchen cabinets—is ten years. If you rebuild an asset to like-new condition after its class life ends, you must treat the cost as a restoration and depreciate it. You can find a list of the class lives for all kinds of assets in IRS Publication 946, How to Depreciate Property (look for the ADS depreciation chart in Appendix B).”
“The IRS has issued proposed
regulations that permit a building owner to elect to recognize a loss when a building structural component such as a roof is replaced, or not make the election and continue to depreciate the replaced component (see Chapter 5). If you elect to take a loss on a replaced component, you must treat the cost of the new component as a restoration and depreciate it.”
“You must also depreciate amounts you spend to adapt a UOP to a new or different use. A use is ‘new or different’ if it is not consistent with your ‘intended ordinary use’ of the UOP when you originally placed it into service. (IRS Reg. § 1.263(a)-3(l).) Adaptations aren’t terribly common in the context of residential rentals.”
“The owner of a hotel building pays to replace all the bathtubs, toilets, and sinks in the guest rooms. This expense constituted an improvement—the restoration of a major component of the building’s plumbing system. Installation of these new plumbing system components also made it necessary to repair, repaint, and retile the bathroom walls and floors in the guest rooms. The building owner must treat these costs as improvements because they directly benefited from, and were incurred by reason of, the improvement to the building. (IRS Reg. § 1.263(a)-3(k)(7), Ex. 24.)”
“To be on the safe side, if you hire a contractor or repairperson to perform both improvements and repairs on a building, ask to be billed separately for each category of work.”
“Jessica owns a two-unit rental. She hires a plumber to install a new bathtub and toilet in one unit and to fix a leak in the plumbing of another unit. The cost of the tub and toilet replacement is an improvement, whereas fixing the leak is a repair. She should have the contractor submit separate invoices for each.”
“A building owner replaces and disposes of the building’s old roof shingles. The owner elects to treat the disposal of these components as a partial disposition of the building and deducts their adjusted basis as a loss. The removal costs need not be depreciated. But, because a loss was taken on the old shingles, the cost of the new shingles must be depreciated as an improvement. (IRS Reg. § 1.263(a)-3(g)(2)(ii), Ex 4.)”
“Note that the cost of demolishing a building must always be depreciated. (I.R.C. § 280B.) For a building other than a certified historic structure, a modification of a building is not a demolition if: (1) 75% or more of the existing external walls of the building are retained in place as internal or external walls, and (2) 75% or more of the existing internal structural framework of the building is retained in place. (Rev. Rul. 95-27, 1995-1 CB 704.)”
“To comply with new building code earthquake standards, a building owner pays for the installation of new expansion bolts to anchor the building’s wooden frame to its cement foundation. This expense was an improvement because it materially increased the building’s strength. The fact the change was made to comply with the building code is irrelevant. (IRS Reg. § 1.263(a)-3(j)(3), Ex. 11.)”
“For more details on this complex topic, visit the IRS Tangible Property Regulations—Frequently Asked Questions webpage at http://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations.”
“Repairs to rental property usually happen after a tenant complains. Document the complaint by writing a note—this can be on your calendar, appointment book, or on an invoice a repairperson gives you. This will help show that something was broken and you had it fixed—which is what a repair is.”
“If you’re doing an extensive repair, take before-and-after photo­ graphs to show the extent of the work and that the property has not been made substantially more valuable.”
“Examples of preventive maintenance include periodically changing the filters on your heating and air conditioning system, and installing zinc control strips on a wood shake or shingle roof to keep fungus and algae away.”
“Under the IRS regulations, expenses that would normally be con­sidered currently deductible repairs must be depreciated along with the rest of the building if they are incurred before the building is placed in service—that is, before it is offered for rent to the public”
“For this reason, you’ll get larger repair deductions if you spend as little money as possible refreshing a building immediately after you buy it. Instead, do as much of this work as possible after the building is offered for rent.”
“Depreciation is an annual tax deduction that business owners and investors take to reflect this annual cost.”
“It’s true that if you sell your property you’ll likely have to pay a tax of up to 25% on the total amount of depreciation deductions you took over the years.”
“In effect, depreciation allows you to defer payment of tax on your rental income from the years in which it was earned to the year it is sold.”
“You must take a depreciation deduction if you qualify for it. If you fail to take it, the IRS will treat you as if you had taken it. This means that when you sell your property, its basis (value for tax purposes) will be reduced by the amount of depreciation you failed to claim. As a result, you’ll have a larger profit from the sale that you’ll have to pay taxes on.”
“To claim such depreciation, you must make what is known as an I.R.C. Section 481(a) adjustment. You can deduct the entire amount in a single year by filing IRS Form 3115 to request a change in accounting method. This type of change ordinarily is granted automatically by the IRS (see Rev. Proc. 2004-11) and you don’t need to file any amended tax returns. Unfortunately, IRS Form 3115 is an extremely complex form. You’ll likely need help from a tax professional to complete it properly.”
“However, one of the major changes of the tax reform law was an increase in the first-year bonus depreciation amount from 50% to 100% starting in 2018 through 2025. This enables landlords to deduct in a single year the full cost of personal property used in a rental activity, as well as certain land improvements. Personal property, including property in rental units, may also be fully deducted using Section 179 expensing.”
“If the land you own permanently disappears due to flooding, earthquake, or some other catastrophe, you’ll have a deductible casualty loss”
“You may not depreciate property you use solely for personal purposes. This means you get no depreciation for your personal residence. If you convert a rental property to personal use, you must stop taking the depreciation for the property.
If you use property for both rental and personal uses, you may depre­ciate only a part of its value, based on the percentage of the property used for rental purposes.”
“Rather, depreciation begins when property is ‘placed in service.’ Property is considered placed in service in a rental activity when it is ready and available to rent.”
“Basis is a word
you’ll hear over and over again when the subject of depreciation comes up. Don’t let it confuse you; it just means the amount of your total investment in the property for tax purposes.”
“Usually, your basis is the cost of the property, plus expenses of the sale such as real estate transfer taxes and other fees. Land cannot be depreciated, so it must be deducted from the cost of real property to determine its basis for depreciation.”
“Personal property can be deducted over its full recovery period using accelerated depreciation, which provides larger depreciation deductions in the early years than the straight-line method”
“Alternatively, the full cost of personal property may usually be deducted in one year using 100% bonus depreciation (in effect 2018 through 2025), Section 179 expensing, or the de minimis safe harbor”
“When a rental property is first placed in service, the landlord gets to depreciate its value. This includes the value of:
• the building and building components
• land improvements, such as landscaping and fences, and
• personal property items that are inside the building, but that
are not physically part of it—for example, refrigerators, stoves,
dishwashers, and carpeting.
These items can all be depreciated together over 27.5 years. However, you have the option of separately depreciating personal property inside a rental property and certain land improvements. This is more complicated but can yield a larger total deduction during the first year or years that you own the property.”
“Landlords typically make additions and improvements to their rental property after it has been placed into service—that is, after it has been made available for rent. These may consist of:
• improvements to the building itself, or building components—for
example, replacing iron pipes with copper
• land improvements, such as planting new trees or shrubbery, and
• adding new personal property to the rental building—for example,
placing a new refrigerator in a rental unit.
You depreciate these additions and improvements separately from the original rental property. Building improvements are depreciated over 27.5 years (starting the year they are placed in service). Land improvements and personal property are depreciated over a shorter term (15 years for land improvements, five or seven years for most personal property).”
“On April 6, Jan purchased a house to use as residential rental property. She made extensive repairs to the house during May and June. By July 5, she had it ready to rent and placed an ad in Craigslist. She rented it in August with the rental date beginning September 1. The house is considered placed in service in July because it was ready and available for rent on that date. Jan can begin to depreciate the house in July.”
“On February 1, Jan buys a house that is already being used as a rental and is currently occupied by a tenant. She continues renting out the unit to the tenant. She can begin to depreciate the house on February 1 because she placed it in service on that date.”
“Keep documentation showing the date your property was placed in service. For example, keep copies of any rental ads or other rental listings you place to rent a newly acquired vacant property.”
“The following costs are “inherently facilitative” and must always be included in the building’s depreciable basis:
• bidding costs, application fees, and similar expenses
• costs to appraise or otherwise determine the property’s value
• architectural, engineering, environmental, geological, or inspection
services for the property—for example, termite inspection fees
• expenses for preparing or reviewing the property’s acquisition docu-
ments, such as bids, offers, sales agreements, or purchase contracts
• costs to negotiate the purchase terms or structure, including
tax advice
• expenses for evaluating and examining the property’s title—for
example, abstract fees and attorneys’ fees
• costs to obtain regulatory approval or secure permits
• property conveyance costs, including sales and transfer taxes
and title registration costs—for example, recording fees and title
insurance fees
• finders’ fees and brokers’ commissions, including amounts con­tingent
on successful closing of the purchase (broker’s commissions are
ordinarily paid by the seller, but include any in your basis if paid
by you, the buyer), and
• the cost of services provided by a qualified intermediary in a like-
kind exchange.
Many of these costs will be listed on the closing statement you receive
after escrow closes.”
“The cost of any repairs or improvements you make to the building before it’s offered for rent must be added to its basis.”
“Fire insurance premiums are operating expenses deducted as paid”
“Not included in your rental property’s basis are
charges connected with getting or refinancing a loan, such as points (discount points, loan origination fees), mortgage insurance premiums, loan assumption fees, credit report costs, and fees for an appraisal required by a lender.”
“Do not include in your basis amounts placed in escrow for the future payment of items, such as taxes and insurance.”
“You cannot use cost as a basis for property that you received:
• in an exchange for other property
• as a gift, or
• as an inheritance.”
“Victoria inherits an apartment building from her late Uncle Ralph. The property’s fair market value (excluding the land) is $300,000 at the time of her uncle’s death. This is Victoria’s basis. She sells the property for $310,000. Her total taxable profit on the sale is only $10,000 (her profit is the sales price minus the property’s tax basis).”
“When you change property you held for personal use to rental use
(for example, you rent your former home), your basis is the lesser of the
following values on the date of the change:
• the property’s fair market value, or
• your adjusted basis.”
“You may also elect to have the property’s value appraised as of the date of its conversion to rental property.”
“Several years ago, John built his home for $140,000 on a lot that cost $14,000. Before changing the property to rental use last year, he added $28,000 of permanent improvements. Because land is not depreciable, John only includes the cost of the house and improvements when figuring his adjusted basis for depreciation—$168,000 ($140,000 + $28,000). The house has a fair market value of $250,000. John must use his adjusted basis of $168,000 as the basis for depreciation on the house because it is less than the fair market value on the date of the conversion to rental use.”
“Jessica purchased a home in Chicago for $250,000; $50,000 of the total cost was for the land. She lived in the home for seven years and then moved to Houston. Because of the poor real estate market, Jessica decided to rent her house instead of sell it. The home’s adjusted basis when she moved out was $200,000. However, due to the decline in real estate values, its fair market value was only $175,000—a loss of $25,000. Jessica must use the $175,000 fair market value as the basis for depreciation on the house because it is less than its adjusted basis on the date of conversion to rental use. If she sells the house instead for $175,000, she has no deductible loss.”
“You do not get a full year’s worth of depreciation for the first year your property is placed in service. Instead, your first-year deduction depends on what month of the year you placed the property into service—the later in the year, the less depreciation you get. No matter what day of the month you place your residential real property into service, you treat it as being placed in service at the midpoint of that month. You then get an extra one-half month of depreciation the year you sell your property. This rule is called the mid-month convention.”
“If your rental is in a condominium complex that is governed by a home­ owners’ association, you may be required to pay special assessments to cover building improvements. Such assessments are depreciated in the same way as any building improvement described above. Special assessments are not the same as the monthly homeowners’ association fees condo owners must pay to cover the condo’s operating expenses. These monthly fees are currently deductible each year as an operating expense.”
“Mona buys a rental house in 2015. In 2018, her old tenant moves out and she hires a contractor to remodel the house, adding a new kitchen and bathroom, and installing new floors. The cost of this building improvement was $50,000. The work was completed on June 1, 2019, and she immediately placed the house into service as a rental unit by offering it for rent. She depreciates the $50,000 over 27.5 years. The beginning date for her first year of depreciation is June 2019. She gets $985 in depreciation for this improvement the first year and $1,835 each year thereafter. She claims this amount in addition to the depreciation she has already been receiving on the house since she placed it in service in 2015. She adds the $50,000 improvement expense to the home’s basis and reduces her basis by the depreciation deductions she takes each year.”
“Alice has owned an apartment building for ten years. She replaces the roof, which is a structural component. Alice may not recognize a loss and must continue to depreciate the retired old roof unless she elects to treat the roof retirement as a partial disposition of the building. If she decides not to make this election, she separately depreciates the cost of the new roof and continues to include the cost of the old roof in the amount she depreciates for the building as a whole. If she does make the election, depreciation on the old roof ceases at the time of its retirement. Alice recognizes a loss upon the retirement equal to the remaining undepreciated basis of the roof.”
“Building components that cost $2,500 or less may be deducted in a single year with the de minimis safe harbor deduction. For example, a bathroom sink is a building component. If a landlord spends $2,000 to replace a bathroom sink the full amount can be deducted that year with the de minimis safe harbor deduction.”
“Changes to the land include grading, clearing, excavations, and land­ scaping. The IRS says that such changes are depreciable only if they are ‘directly associated’ with a building, rather than ‘inextricably associated’ with the land itself. (Rev. Rul. 65-265.) Translated into English, this means that these land improvements are depreciable if they are intended for use with a specific building. Changes that permanently improve the land itself are not depreciable.”
“Milt plants some new bushes and trees right next to his rental triplex. If he replaced the building, he’d have to destroy these bushes and trees. They have a determinable useful life so he may depreciate them.”
“Milt also plants trees and bushes around the outer boundary of his lot. These trees and bushes would not have to be replaced if the building was demolished. Thus, they can’t be depreciated and Milt must instead add their cost to the basis of his land.”
“Permanent structures other than buildings include fences, outdoor lighting, swimming pools, driveways, paved parking areas and other pavements, sidewalks and walkways, sprinkler systems, and drainage facilities.
In contrast to changes to land, depreciation of permanent structures other than buildings is straightforward—they are depreciated over 15 years as described below or using bonus depreciation.”
“Bonus depreciation may be used to deduct land improvements that have a 15-year recovery period. During 2018 through 2025, 100% of the cost of these land improvements can be deducted in one year using bonus depreciation.”
“Land improvements can always be depreciated using regular depreciation. Regular depreciation for land improvements is done over 15 years, using the 150% declining balance method.”
“you can determine the cost by using construction cost guides such as the National Repair & Remodeling Estimator (Craftsman Book Company, available as a download at http://www.craftsman-book.com).”
“Often it is easy to tell whether or not an item is a structural component of a rental building—for example, refrigerators and other kitchen appliances are not structural components, while load-bearing walls obviously are. Other examples of items inside rental buildings that are not structural components include:
• carpeting that is tacked down (but not glued down)
• drapes and blinds
• furniture (only depreciable if you own it)
• personal signs
• movable and removable partitions
• laundry equipment in a laundry room
• weights and other exercise equipment in an exercise room
• pool tables, ping-pong tables, televisions, and other recreational
equipment in a recreation room, and
• office furniture and equipment located in a manager’s office.”
“You must separately depreciate or deduct personal property that you add to a building after you place it into service—for example, if you install a new stove or refrigerator in a rental property you’ve already made available for rent, you’ll depreciate it separately from the other appliances already in the unit.”
“Bonus depreciation enables a landlord to deduct a substantial percentage of a long-term asset’s cost in a single year, instead of depreciating the full cost over many years. Bonus depreciation has been around for years, with the bonus percentage set at 50% most of the time. However, the Tax Cuts and Jobs Act has vastly expanded its scope. The bonus amount has been increased from 50% to a whopping 100% for the next five years—in other words, the entire cost of an asset can be deducted in one year with bonus depreciation through 2022.”
“Bonus depreciation is optional—you don’t have to take it if you don’t want to. If you don’t want to take it, you must inform the IRS as described below. But if you want to get the largest depreciation deduction you can, you’ll want to take advantage of the bonus.”
“Refrigerators are five-year property, so you must take bonus depreciation that year for any other five-year property—for example, computers and office equipment.”
“Property acquired before September 28, 2017 is subject to a 50% bonus depreciation rate if it was placed in service in 2017, 40% if placed in service in 2018, 30% if placed in service in 2019, and 0 if placed in service after 2019.”
“For example, if you use your computer 25% for your rental business, you may deduct 25% of the cost the first year with bonus depreciation. However, you must use listed property (primarily cars and light trucks) over 50% of the time to qualify for bonus depreciation.”
“There are no dollar limits on the total bonus depreciation deduction you may take each year. You may take your full deduction even if it exceeds your income for the year resulting in a net operating loss.”
“In other words, you have to give back the bonus depreciation deductions you took and pay tax on them. However, because personal property usually declines rapidly in value, amounts earned when it is resold are typically small, limiting the amount of income to be recaptured. Additionally, because of the time value of money, taking a large deduction this year is worthwhile even if you’ll have to pay some of it back in later years.”
“Bonus depreciation is applied automatically to all taxpayers who qualify for it. However, the deduction is always optional. You need not take it if you don’t want to. You can elect not to take the deduction by attaching a note to your tax return. It may be advantageous to do this if you expect your income to go up substantially in future years, placing you in a higher tax bracket; or if bonus depreciation will result in losses you’re unable to deduct because of the passive loss rules”
“When you opt out, you do so for the entire class of assets. It’s very important to understand that if you opt out of the bonus, you must do so for the entire class of assets, not just one asset within a class. This is the same rule that applies when you decide to take the bonus.”
“Bonus depreciation has some advantages over the de minimis safe harbor: there is no $2,500 per item ceiling on bonus depreciation. Moreover, property deducted with the safe harbor won’t count for purposes of taking the pass-through deduction in effect from 2018 through 2025. At higher income levels ($207,500 for singles and $315,000 for marrieds) this deduction can be limited to 2.5% of the cost of a landlord’s depreciable property. This would not include property you’ve deducted using the safe harbor but can include property deducted with bonus depreciation (or Section 179). (See Chapter 7 for a full discussion of the pass-through tax deduction.) For this reason, if you want to maximize your pass-through deduction, you may wish to avoid using the de minimis safe harbor and use bonus depreciation instead. You elect to use the safe harbor each year and you can use it some years and not use it others.”
“In determining whether the cost of an item exceeds the $2,500 (or $5,000) threshold, you must include all additional costs included on the same invoice with the property—for example, delivery and installation fees. If the additional costs on a single invoice apply to several items, you must divide the costs among them in a reasonable way. IRS regulations give you three options: (1) equal division for each item, (2) specific identification (for example, if the installation costs apply only to one item), or (3) weighted average based on the property’s relative cost.”
“One exception where the materials and supplies deduction could prove useful, even where a de minimis safe harbor election is made, is for components used to repair property. If the components cost more than $2,500 the de minimis safe harbor can’t be used. But the materials and supplies deduction can be used, no matter how much the components cost. The deduction may be taken in the year when the components are actually used in the course of a repair or maintenance.”
“Section 179 of the tax code is similar to bonus depreciation in that it allows you to deduct in one year the entire cost of personal property you use in your business. This is called first-year expensing or Section 179 expensing. (Expensing is an accounting term that means currently deducting a long-term asset.) Section 179 may be used to deduct much the same property as bonus depreciation. However, during 2018 through 2022, Section 179 will likely not be used much by landlords because they can deduct 100% of the cost of the same property with bonus depreciation.”
“First, you can’t use Section 179 to deduct more in one year than your net taxable business income for the year (not counting the Section 179 deduction but including your spouse’s salary and business income). Undeductible amounts are carried forward to be deducted in future years. Thus, Section 179 may never result in a loss. There is no such limitation on bonus depreciation.”
“In addition, you may only use Section 179 for property you use over 50% of the time for business (this isn’t the case with bonus depreciation, except for listed property—primarily cars and light trucks); if your use of the property falls below 50% you have to give back your Section 179 deduction through recapture (see below).”
“Section 179 can only be used if your rental activities qualify as a business for tax purposes. You can’t use it if your rental activity is an investment, not a business. Bonus depreciation may be used for either business or investment activities.”
“Finally, there is an annual limit on the amount of property that can be deducted with Section 179. For 2018, the limit is $1 million.”
“Unlike bonus depreciation, Section 179 expensing is not automatic. If you want to use it, you must elect to use it by completing IRS Form 4562, and checking a specific box. Also, unlike bonus depreciation, Section 179 does not apply class-wide. You may pick and choose which personal property you wish to deduct with this method.”
“However, you may need to use regular depreciation to write off the cost of long-term
personal property assets that don’t qualify for these methods. For example, you can’t use any of these methods for:
• personal property items that you convert to business use
• items purchased from a relative, or
• property inherited or received as a gift or inheritance.
In all these cases, you must deduct the personal property involved with regular depreciation.”
“Miranda converts her personal lawn mower to rental use. Its basis is $400. She uses the lawn mower 75% of the time for her rental business and 25% of the time to mow her own lawn. Her depreciable basis in the mower is reduced by 25%, so her basis is $300 instead of $400 (75% × $400 = $300). Miranda can depreciate $300 over the asset’s depreciation period.”
“Computer software (software included in the price of a
computer is depreciated as part of the computer, unless
you’re billed separately for the software; other software is
separately depreciated.)” –> Depreciation period: 3 years
“Computers and their peripheral equipment 5 years
Office machinery, such as typewriters, calculators, and copiers
Automobiles
Light trucks (actual weight less than 13,000 pounds)
Appliances, such as stoves, refrigerators, dishwashers, washing
machines, clothes dryers, and window air conditioners
Carpets
Furniture used in rental property
Drapes and blinds” –> Depreciation period: 5 years
“Office furniture and equipment, such as desks and files
Cellphones, riding lawn mowers, snow blasters
Any property that does not have a class life and that has
not been designated by law as being in any other class” –> Deprecation period: 7 years
“Shrubbery
Permanent fences
Sidewalks
Driveways
Paved parking area
Landscaping
Sewer and drainage facilities
Swimming pools” –> deprecation period: 15 years
“The basic rule is that, no matter when you buy personal property, you treat it as being placed in service on July 1—the midpoint of the year.”
“You are not allowed to use the half-year convention if more than 40% of the long-term personal property you buy during the year is placed in service during the last three months of the year.”
“It’s usually best to avoid having to use the mid-quarter convention, which means you’ll want to buy more than 60% of your total depreciable personal property for your rental activity before September 30 of the year.”
“If you use listed property for your rental activity more than 50% of the time, you may deduct its cost just like any other long-term personal property under the normal depreciation rules. However, if you use listed property 50% or less of the time for your rental activity, you must use the straight-line method—the slowest method of depreciation. And, the property doesn’t qualify for the 50% bonus depreciation. You also can’t use the normal depreciation periods allowed under the MACRS depreciation system. Instead, you must use the depreciation periods provided for by the Alternative Depreciation System (ADS for short).”
“Each year, you must subtract from the property’s basis the amount of depreciation allowed for the property—this is true regardless of whether you actually claimed any depreciation on your tax return. If you hold on to your property for the full recovery period—27.5 years for residential rental property—your adjusted basis will be reduced to zero, and there will be nothing left to depreciate.”
“You must increase the basis of any property by:
• the cost of any additions or improvements
• amounts spent to restore property after it is damaged or lost due to
theft, fire, flood, storm, or other casualty (see Chapter 14)
• the cost of extending utility service lines to the property, and
• legal fees relating to the property, such as the cost of defending and
perfecting title.”
“Thus, reductions in basis can increase your tax liability when you sell your property because they will increase your gain. Increases in basis will reduce your gain and therefore your tax liability.”
“However, if you convert the last property you exchange into your personal residence, you can permanently exclude up to $500,000 of your gain from its sale. You must own the property for at least five years and live in it for at least two years to qualify for this exclusion.”
“You must identify the replacement property for your property within 45 days of its sale. And your replacement property purchase must be completed within 180 days of the initial sale. Because of these time limits, it’s a good idea to have a replacement property lined up before you sell your property. Professional exchange companies (also called accommodators or facilitators) can help you find replacement property and handle the transaction for you. You can find listings for such companies through the website of the Federation of Exchange Accommodators at http://www.1031.org.
For more information on real property exchanges, see IRS Publication 544, Sales and Other Dispositions of Assets, and IRS Inst. 8824, Instructions for Form 8824, Like-Kind Exchanges.”
“To qualify for the $250,000/$500,000 home sale exclusion you (or your spouse or former spouse) must own and occupy a home as your principal residence for at least two of the five years before you sell it. This means that the home may not be a rental property during those two years.”
“There is an important limit on the $250,000/$500,000 exclusion: It does not apply to any depreciation deductions taken on the property after May 6, 1997. You must reduce your applicable exclusion by the total amount of depreciation you were entitled to take during these years—that is, you must include the amount as ordinary income on your tax return.”
“For more information on the home sale exclusion, refer to IRS Publication 523, Selling Your Home.”
“You must report depreciation on IRS Form 4562, Depreciation and Amortization (Including Information on Listed Property). Carry over the amount of your depreciation to your Schedule E and subtract it from your gross rental income along with your other rental expenses.”
“Use a tax software program for Form 4562. Form 4562 is one of the most complex and confusing IRS forms. If you want to complete it yourself, do yourself a favor and use a tax preparation program.”
“You need to keep accurate records for each asset you depreciate showing:
• a description of the asset
• when and how you purchased the property
• the date it was placed in service
• its original cost
• the percentage of time you use it for business
• the amount of depreciation you took for the asset in prior years,
if any
• the asset’s depreciable basis
• the depreciation method used
• the length of the depreciation period, and
• the amount of depreciation you deducted for the year.”
“Most people don’t give their land valuation much thought; they simply use a standard formula or their property tax bill to determine its value. But, as ­explained below, there are other ways to value your land and buildings that may yield much better results.”
“Many accountants and tax preparers use a standard ratio for every property—for example, 75% or 80%. They don’t bother to look at any evidence of the property’s value, such as the county tax assessor’s valuation or lender’s appraisal. Don’t use this method—it leaves much to be desired. If the IRS audits you and questions the ratio, you’ll have no evidence to back it up.”
“Most landlords determine their improvement ratios by using their property tax bill. The bill usually provides a valuation of the land and buildings together, and a value for each alone, or for just the buildings alone. The ratio is determined by ­dividing the assessed improvement value by the total assessed value of the ­property (assessed improvement value ÷ total assessed value = improvement ratio).”
“Suzy buys a rental duplex with a total basis of $200,000 (purchase price + depreciable sale expenses). The property tax bill lists the property’s total value at $160,000, and provides that the improvements are worth $110,000 and the land $50,000. According to the county tax assessor, therefore, the property has a 69% improvement ratio. ($110,000 ÷ $160,000 = 69%.) Using this percentage, her depreciable basis is $138,000. (69% × $200,000 = $138,000.) She may use this amount to determine her depreciation each year.”
“If you borrowed money from a bank or other lender to acquire the property, the lender almost certainly required an appraisal before approving your loan. You should make sure to obtain and keep a copy of the appraisal. It should contain the appraiser’s estimate of how much it would cost to replace the structure and how much the land is worth. This may be in the section of the appraisal report called cost approach. The appraiser provides an estimate of how much it would cost to replace the structure with an identical new structure, and then reduces this amount with an allowance for depreciation, depending on the age of the building. The a ­ ppraiser also gives an estimate of the cost of replacing improvements other than the building—for example, walkways. These are added together to come up with the total replacement cost—often called indicated value by cost approach. The IRS will probably accept the appraiser’s valuation, unless it’s clearly unreasonable.”
“Well-qualified real estate appraisers ordinarily belong to the Appraisal Institute and use the initials MAI (Member of the Appraisal Institute). You can find a directory of MAI appraisers at http://www.appraisalinstitute.org.”
“The Marshall & Swift Valuation Service has a website that will calculate the replacement cost of a building for you (www.swiftestimator.com). All you have to do is plug in detailed information about the structure—its size, building ­materials, age, location, and so forth.”
“• The National Building Cost Manual (Craftsman Book Company;
http://www.craftsman-book.com)
• The National Construction Estimator (Craftsman Book Company), and
• Walker’s Building Estimator’s Reference Book (Frank R. Walker Co.,
http://www.frankrwalker.com).”
“Miranda wants to figure the replacement value of her duplex herself. She refers to the National Building Cost Manual in her local library. It tells her that the cost to build a four-unit building like hers of average quality is $60 per square foot. Her building contains 3,000 square feet, resulting in a $180,000 replacement cost. However, the $180,000 amount represents the cost to build a brand-new building. Miranda’s building is five years old. The National Building Cost Manual tells Miranda that a building like hers has approximately a 55-year useful life and will be worth 88% of its original cost after five years. 88% of $180,000 equals $158,400. This is the true approximate value of Miranda’s building. This amount gives her an improvement ratio of 79% ($158,400 ÷ $200,000 = 79%). This is better than the 75% improvement ratio she obtained using the appraiser’s valuation. She decides to use this improvement ratio to calculate her depreciation. She takes care to keep all the documentation showing how she calculated her duplex’s replacement value, including making copies of the relevant pages from the National Building Cost Manual.”
“Starting September 28, 2017 and lasting through December 31, 2022, 100% of the cost of personal property and land improvements in rental property can be deducted in a single year with bonus depreciation. Moreover, bonus depreciation may now be used for both new and used property.”
“You can access the guide, Cost Segregation Audit Techniques Guide, for free on the IRS website at http://www.irs.gov (search under ‘cost segregation’).”
“Before you go ahead with your cost segregation study, you should be aware that this process has some potentially serious drawbacks—for example:
• your enhanced depreciation may not result in any extra tax savings because of the passive loss rules
• you’ll have to pay back your enhanced deductions when you sell your property—a process called recapture, and
• you won’t be able to use a like-kind exchange to defer tax on the personal property you deducted using cost segregation.”
“You can always perform a cost segregation study the first year you own or construct rental property, but you don’t have to do it that year. You can wait until a future year—perhaps when you have enough rental or other passive income to make use of the speeded-up depreciation deductions.”
“The difference between what was deducted and what could have been deducted is known as an I.R.C. Section 481(a) adjustment.”
“An online fee-based calculator to help calculate such a 481(a) adjustment is available at http://www.kbkg.com/481a-calculator.”
“Although not absolutely required by the IRS, you may wish to hire an engineer to conduct a cost segregation study to determine how to classify and value your property’s various components.”
“A directory of cost segregation specialists can be found at the website of the American Society of Cost Segregation Professionals (http://ascsp.org).”
“Such a study can be expensive—typically $5,000 to $10,000 or more—but the cost is a tax deductible business expense. Whether paying for such a study makes sense for you depends on how much your rental property is worth. The speedier depreciation you’ll obtain may justify the expense if your property is worth $750,000 or more (not counting the value of the land).”
“Land improvements consist of such elements as:
• site walls
• landscaping and shrubbery
• driveways and walks
• fencing
• decks and patios, and
• other site improvements directly associated with a building, such as grading and excavating”
“To qualify for the pass-through deduction, your rental activity must constitute a business, not an investment activity.”
“As discussed in detail in Chapter 1, the IRS and courts have both found that ownership of even one rental unit can constitute a business for tax purposes. Thus, most residential landlords should qualify as a business for purposes of this deduction.”
“Luckily, virtually all landlords operate as a pass-through business. This is so whether you own your rental property:
• individually
• jointly with one or more individuals as tenants in common, or as a joint tenancy with your spouse
• as an owner of a one-member or multimember limited liability
company (LLC)
• as a partner in a partnership, or
• as an S corporation shareholder (S corporations are rarely used for rental property).”
“Landlords may qualify to deduct from their income tax up to 20% of their “qualified business income” (“QBI”). QBI is the net income (profit) your rental business earns during the year. You determine this by subtracting all your regular rental deductions from your total rental income.”
“It should be clear that you can benefit from the pass-through deduction only if your rental business earns a profit for the year. You get no deduction if your rental activity shows a net loss because your QBI will be zero.”
“However, you do not include net capital gains for the year in your taxable income (such amounts already receive preferential tax treatment).”
“Your pass-through deduction can never exceed 20% of your taxable income. This limitation will apply and reduce your pass-through deduction to less than 20% of QBI, if you don’t have enough nonbusiness income to offset your personal deductions which reduce your taxable income below the amount of your qualified business income.”
“Hal and Wanda are married and file jointly. Their taxable income this year is $500,000, including $100,000 in QBI they earned from their rental business they own through an LLC. They have no employees. They own an apartment building they bought four years ago for $600,000. The land is worth $100,000, so its unadjusted acquisition basis is $500,000. Their maximum possible pass-through deduction is 20% of their $100,000 QBI, which equals $20,000. However, since their taxable income was over $415,000, their pass-through deduction is limited to the greater of (1) 50% of W-2 wages, or (2) 25% of W-2 wages plus 2.5% of their apartment building’s $500,000 basis. (1) is 0 (2) is $12,500 (2.5% x $500,000) + (25% x 0) = $12,500. Their pass-through deduction is $12,500.”
“The pass-through deduction is a personal deduction you may take on your Form 1040 whether or not you itemize. You don’t take it on Schedule E. There will likely be a separate tax form to be completed to claim the deduction, which has yet to be devised by the IRS. You’ll then transfer the amount of the deduction to a line on your Form 1040.”
“A landlord’s most common deductible interest payments are:
• mortgage interest payments to banks and other financial institutions on loans used to acquire rental property
• mortgage interest payments to financial institutions on loans used to improve rental property
• interest on credit cards for goods or services used in a rental activity, and
• personal loans for any item used in a rental activity.”
“One way to use real estate to get cash is to do a “cash-out refinancing”— obtain a new loan to pay off your old loan, plus borrow more money to end up with cash in your pocket. However, you may not deduct the interest on the cash-out portion of the loan unless you use the money to do real estate improvements (or to pay for certain medical or education expenses).”
“Joe owns a rental house with a fair market value of $100,000. He sells the property to Jean. Jean pays $120,000. She puts down $20,000 and Joe finances the remainder himself, charging Jean only 2% interest. He pays 20% capital gains tax on his gain on the sale ($120,000 minus his $60,000 basis), and ordinary income tax on the interest payments Jean will make—taxed at Joe’s top 24% income tax rate. Joe comes out ahead on the deal by getting a higher sales price for the property and charging less interest.”
“Unfortunately for sellers, the IRS is well aware of this scheme. If an installment sale contract does not provide for adequate interest, part of the sales price must be treated as interest for tax purposes. This amount is called ‘unstated interest’ or ‘original issue discount,’ depending upon the circumstances.”
“You get no deduction if you use the loan proceeds to buy something for your personal use—for example, you take a vacation or buy new appliances for your residence. Personal interest is not deductible, except for interest paid for a mortgage to purchase or improve a personal residence or second home, subject to a loan ceiling ($750,000 for property acquired 2018 through 2025) (and some interest on student loans).”
“You may get a deduction if you use the loan for investment purposes—for example, to purchase stocks or bonds or some other investment. You can deduct investment interest as an itemized personal deduction. However, you can deduct investment interest only from investment income. Thus, if you have no investment income, you get no deduction. If your interest expense exceeds your investment income, you cannot deduct the overage. You must carry it forward to deduct in a future year when you have enough investment income.”
“Common start-up expenses for landlords include:
• minor or incidental repairs to get a rental property ready to rent
• outside office expenses paid for before a rental business begins, such as office rent, telephone service, utilities, office supplies, and office equipment rental
• home office expenses
• the cost of investigating what it will take to create a successful residential rental business, including research on potential real estate markets
• insurance premiums (but not title insurance)
• maintenance costs for a rental property paid for before the property is offered for rent—for example, landscaping and utilities (but not the cost of connecting utilities)
• costs for recruiting and training employees before the business opens—for example, hiring and training an apartment manager
• costs to create and set up a website
• fees paid to a market research firm to analyze the demographics, traffic patterns, and general economic conditions of a neighborhood
• business licenses, permits, and other fees, and
• fees paid to lawyers, accountants, consultants, and others for professional services; however, legal and other fees paid to purchase a rental property are not start-up expenses.”
“However, a special tax rule allows you to deduct up to $5,000 in start-up expenses the first year you are in business, and then deduct the remainder, if any, in equal amounts over the next 15 years.”
“The IRS and tax court have taken a very narrow view of what con­stitutes a rental business. They have held that a landlord’s rental business only exists in the geographic area where the property is located. Thus, a landlord who buys (or seeks to buy) property in a different area is starting a new rental business. This means the expenses for expanding in the new location are start-up expenses.”
“However, you won’t be entitled to the full $5,000 first-year deduction if you have more than $50,000 in start-up expenses. Your first-year deduction is reduced by the amount by which such start-up expenditures exceed the $50,000 limit. For example, if you have $53,000 in start-up expenses, you may only deduct $2,000 the first year, instead of $5,000. If you have $60,000 or more in start-up expenses, you get no current deduction. The whole amount must be deducted over 180 months.”
“Only people engaged in a business can deduct start-up expenses. Investors in real estate are not considered to be ‘in business’ for tax purposes. (Sorrell v. Comm’r., 882 F.2d 484 (11th Cir.1989).)”
“For tax purposes, the cost of the rental property includes not just the purchase price, but expenses related to the purchase, including:
• bidding costs, application fees, and similar expenses
• costs to appraise or otherwise determine the property’s value
• architectural, engineering, environmental, geological, or inspection services for the property—for example, termite inspection fees
• expenses for preparing or reviewing the property’s acquisition documents, such as bids, offers, sales agreements, or purchase contracts
• costs to negotiate the purchase terms or structure, including tax advice
• expenses for evaluating and examining the property’s title—for example, abstract fees and attorneys’ fees
• costs to obtain regulatory approval or secure permits
• property conveyance costs, including sales and transfer taxes and title registration costs—for example, recording fees and title insurance fees
• finders’ fees and brokers’ commissions including amounts contingent on successful closing of the purchase, and
• the cost of services provided by a qualified intermediary in a like-kind exchange. (IRS Reg. § 1.263(a)-2.)
You cannot deduct any of these expenses as start-up expenses.”
“Travel expenses to get your rental business going are deductible start-up expenses with one important exception: Travel costs to buy a particular rental property are not start-up expenses. Instead, they are capital expenses that must be added to the cost of the property and depreciated.”
“Costs you pay to form a partnership, limited liability company, or corporation are not part of your start-up costs. However, under a different rule, you can deduct $5,000 of these costs the first year you are in business and any amount remaining over the first 180 months you are in business.”
“If you form a single-member LLC, don’t spend more than $5,000 in organizational expenses. Because single-member LLCs are considered ‘disregarded entities’ for tax purposes, the IRS doesn’t allow these entities to deduct organizational expenses over $5,000. Instead any expenses over that amount must be capitalized, which means they would not be deductible until the LLC is dissolved.”
“You are entitled to the home office deduction if:
• your rental activities qualify as a business
• you use your home office exclusively for your rental business, and
• you use your home office for rental business on a regular basis.
After you meet these three threshold requirements, you must also satisfy any one of the following four requirements:
• you regularly and exclusively use your home office for administrative or management activities for your rental business and have no other fixed location where you regularly perform such activities
• you perform your most important rental activities at your home office
• you meet business-related visitors, such as tenants, at your home office, or
• you use a separate structure on your property exclusively for rental business purposes.”
“For example, if your home office is 400 square feet, and your entire home is 1,600 square feet, 25% of your home is used for your office.”
“You have a direct home office expense when you pay for something just for the home office portion of your home. This includes, for example, the cost of painting your home office, carpeting it, or hiring someone to clean it. The entire amount of a direct home office expense is deductible.
Virtually anything you buy for your office is deductible. However, you may have to depreciate permanent improvements to your home over 39 years, rather than deduct them in the year when you pay for them.”
“An indirect expense is a payment for something that benefits your entire home, including both the home office portion and your personal space. You may deduct only a portion of this expense—the home office percentage of the total.”
“However, starting in 2018 and continuing through 2025, the itemized deduction for property taxes is limited to $10,000 per year. Also, for homes purchased in 2018 through 2025, the deduction for home mortgage interest is limited to acquisition loans for a main and second home totaling a maximum of $750,000.”
“Landlord Ed pays $12,000 per year in property tax on his home. He uses 25% of the home as an office for his residential rental business. This enables him to deduct $3,000 of his property tax (25%) as part of his home office deduction. He deducts the remaining $9,000 as a personal itemized deduction on his Schedule A. Had he not had a home office, he could have deducted only $10,000 of his $12,000 in property tax.”
“If you own your home, you’re also entitled to a depreciation deduction for the office portion of your home.”
“You may deduct your home office percentage of your utility bills for your entire home, including electricity, gas, water, heating oil, and trash removal.”
“Both homeowners’ and renters’ insurance are partly deductible as indirect home office expenses. However, special insurance coverage you buy just for your home office—for example, insurance for your computer or other rental business equipment—is fully deductible as a direct expense.”
“You can deduct the home office percentage of home maintenance expenses that benefit your entire home, such as housecleaning of your entire house, roof and furnace repairs, and exterior painting. Home maintenance costs that don’t benefit your home office—for example, painting your kitchen—are not deductible at all.”
“Casualty losses that affect your entire house—for example, a leak that floods your entire home—are deductible in the amount of your home office percentage. Casualty losses that affect only your home office, for example a leak that floods only the home office area of the house, are fully deductible direct expenses. Casualty losses that don’t affect your home office—for example, if only your kitchen floods—are not deductible as business expenses.”
“Security system costs are partly deductible as an indirect expense if your security system protects your entire home. If you have a security system that protects only your home office, the cost is a fully deductible direct expense.”
“For example, you can deduct the cost of driving from home to perform maintenance at your rental property. If you don’t have a home office, these costs are not deductible.”
“You cannot deduct more than the net profit you earn from a business you run from your home office.”
“If your deductions exceed your profits, you can deduct the excess in the following year and in each succeeding year until you deduct the entire amount, assuming you earn profits in these years. There is no limit on how far into the future you can deduct these expenses; you can claim them even if you are no longer living in the home where they were incurred.”
“As long as you live in your home for at least two out of the five years before you sell it, the profit you make on the sale—up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly—is not taxable.”
“However, you will have to pay a capital gains tax on the depreciation deductions you took after May 6, 1997 for your home office. This is the deduction you are allowed for the yearly decline in value due to wear and tear of the portion of the building that contains your home office. (See Chapter 5 for more information on depreciation deductions.) These recaptured deductions are taxed at a 25% rate (unless your income tax bracket is lower than 25%).”
“You can avoid such depreciation recapture if you use the new simplified method of calculating the home office deduction (see “Simplified Home Office Deduction Method,” below). When you use this method, you deduct $5 per square foot of your home office and your depreciation deduction for the home office is deemed to be zero for the year. Thus, you have no depreciation recapture when you sell your home. Also, the adjusted basis of your home does not change.”
“As long as you meet all the requirements to qualify for the home office deduction discussed above, you have the option of using a much simpler method to calculate your home deduction. Using this method, you just deduct $5 for every square foot of your home office. All you need to do is get out your measuring tape.”
“Sounds great, but what’s the catch? The catch is that when you use the simplified method your home office deduction is capped at $1,500 per year. You’ll reach the cap if your home office is 300 square feet. Even if your home office is 400 square feet, you’ll still be limited to a $1,500 home office deduction if you use the simplified method. You can’t carry over any part of the deduction to future years.”
“If your rental activity qualifies as a hotel business because you engaged in short-term rentals, you may have to file Schedule C. (See Chapter 16 for more information.)”
“Transportation expenses are a red flag for the IRS. Car and other local transportation expenses are always a key item for IRS auditors.”
“You can deduct the cost of driving to:
• your rental property
• where you have your principal place of business for your rental activity, including a home office
• places where you meet with tenants, suppliers, vendors, repair­ people, attorneys, accountants, real estate brokers, real estate managers, and other people who help in your rental activity
• the garbage dump where you haul refuse from your rental property
• a local college where you take landlord-related classes (educational expenses are deductible only if your rental activities qualify as a business; see Chapter 15), or
• a store where you buy supplies or materials for your real estate activity.”
“Any use of your car by another person qualifies as a deductible business expense if it is directly connected with your business. Thus, for example, you can count as business mileage a car trip your employee, spouse, or child takes to deliver an item for your rental business or for any other business purpose.”
“Landlords who are investors get the same transportation deductions as landlords who are in business, as long as their home office meets the requirements for the home office deduction. If it does, then their home office is treated as their principal place of business for the transportation deduction. This is so, even though the home office deduction itself is limited to landlords who are in business.”
“If you don’t have a home office that qualifies as your principal place of business, your transportation deductions will be limited by the com­muting rule. Commuting expenses are nondeductible personal expenses. Commuting means driving from where you live to your main or regular place of work for your rental activity.”
“Once you arrive at your rental office or rental property, you may deduct trips to other rental-related locations. But not trips back home.”
“Travel between your home and a temporary work location is not considered commuting and is therefore deductible. A temporary work location is any place where you perform work for your rental activity on an irregular basis with the reasonable expectation that the work there will last one year or less.”
“Sue travels from home to her local college to attend a three-day seminar on rental property management. This is not commuting so she can deduct the travel expense.”
“The IRS sets the standard mileage rate each year. For 2018, the rate is 54.5 cents per mile. To figure out your deduction, simply multiply your business miles by the applicable standard mileage rate.”
“If you choose the standard mileage rate, you cannot deduct actual car operating expenses—for example, maintenance and repairs, gasoline and its taxes, oil, insurance, and vehicle registration fees.”
“And you can’t deduct the cost of the car through regular or bonus depreciation or Section 179 expensing, because the car’s depreciation is also factored into the standard mileage rate (as are lease payments for a leased car).”
“The only actual expenses you can deduct (because these costs aren’t included in the standard mileage rate) are:
• parking fees and tolls for rental-related trips (but you can’t deduct parking ticket fines or the cost of parking your car at your place of work)
• interest on a car loan (deductible as business interest), and
• personal property tax you paid when you bought the vehicle, based on its value—this is often included as part of your auto registration fee.”
“You must use the standard mileage rate in the first year you use a car for your rental activity or you are forever foreclosed from using that method for that car.”
“You can’t use the standard mileage rate if you have five or more cars that you use for your rental activity simultaneously.”
“This means that you could buy an SUV (or van, truck, pickup, or RV) weighing more than 6,000 pounds for your rental business and deduct the entire cost in the first year if you used it 100% for your rental business.”
“Report your local transportation deduction on Line 6 of IRS Schedule E. Combine it with your travel expenses (see Chapter 18). You must also complete and file Part V of IRS Form 4562, Depreciation and Amortization (Including Information on Listed Property). This form requires that you answer the following questions about your vehicle use:
• total business/investment miles driven during the year
• total commuting miles driven during the year
• total other personal (noncommuting) miles driven during the year, and
• whether you had another vehicle available for personal use.”
“If you don’t stay overnight, your trip will not qualify as travel. How­ever, this does not necessarily mean that you can’t take a tax deduction. Local trips for your rental activity are also deductible (see Chapter 11), but you are entitled to deduct only your transportation expenses—the cost of driving or using some other means of transportation. You may not deduct meals or other expenses like you can when you travel and stay overnight.”
“Your tax home is the entire city or general area where your principal place of business for your rental activity is located. If you run your rental activity out of your residence, your tax home is the city or area where you live.”
“The IRS doesn’t care how far you travel for business. You’ll get a deduction as long as you travel outside your tax home’s city limits and stay overnight. Thus, even if you’re just traveling across town, you’ll qualify for a deduction if you manage to stay outside your city limits.”
“Examples of rental business purposes include:
• traveling to your rental property to deal with tenants, maintenance, or repairs
• traveling to building supply stores or other places to obtain materials and supplies for your rental activity
• traveling to your rental property to show it to prospective tenants
• learning new skills to help in your rental activity, by attending landlord-related classes, seminars, conventions, or trade shows, and
• traveling to see people who can help you operate your rental activity, such as attorneys, accountants, or real estate brokers.
On the other hand, rental-related activities do not include:
• sightseeing
• recreational activities that you attend by yourself or with family or friends, or
• attending personal investment seminars or political events.”
“Travel for building improvements is not deductible. You cannot deduct the cost of traveling away from home if the primary purpose of the trip is to improve your rental property. The cost of travel for improvements must be added to the cost of the improvement and recovered by taking depreciation over many years. In contrast, travel costs for repairs are currently deductible operating expenses.”
“Expenses you incur to look at a property you end up buying must be added to the basis of your property and depreciated over 27.5 years along with the rest of the property.”
“If you look at rental property on a trip, but don’t buy it, your travel expenses can be currently deductible as an operating expense, but only if you are already engaged in a rental business in the geographic area where the property is located.”
“Transportation expenses are the costs of getting to and from your destination—for example:
• fares for airplanes, trains, or buses
• driving expenses, including car rentals
• shipping costs for your personal luggage or other things you need for your rental activity, and
• 50% meal and beverage expenses, and 100% lodging expenses you incur while en route to your final destination.”
“You may deduct the expenses you pay for a person who travels with you only if he or she:
• is your employee
• has a genuine business reason for going on the trip with you, and
• would otherwise be allowed to deduct the travel expenses.
These rules apply to your family as well. This means you can deduct the expense of taking your spouse, child, or other relative only if the person is your employee and his or her presence is essential to your rental activity.”
“You may deduct 100% of your transportation expenses only if you spend more than half of your time on rental activities while at your destination. In other words, your rental activity days must outnumber your personal days.”
“For 2018, the standard meal allowance ranged from $51 per day for travel in the least expensive areas to up to $74 for high-cost areas, which includes most major cities. And because you can generally deduct only half of your meal expenses, your deduction is limited to one-half of the federal meal allowance.”
“The standard meal allowance is revised each year. You can find the current rates for travel within the United States on the Internet at the U.S. General Services Administration website at http://www.gsa.gov.”
“If you have the right to direct and control the way a worker performs—both the final results of the job and the details of when, where, and how the work is done—then the worker is your employee. On the other hand, if you have only the right to accept
or reject the final results the worker achieves, then that person is an IC.”
“People who offer their services to the general public are almost always independent contractors. This includes most of the people landlords hire—for example:
• repairmen
• construction contractors
• gardeners
• plumbers
• electricians
• carpet layers
• painters
• roofers, and
• people who provide professional services to the public, such as real estate brokers, real estate appraisers, architects, real estate management companies, lawyers, accountants, and bookkeepers.”
“If you pay an unincorporated IC $600 or more during the year by cash, check, or direct deposit for business-related services, you must:
• file IRS Form 1099-MISC telling the IRS how much you paid the worker, and
• obtain the IC’s taxpayer identification number.”
“If you pay an independent contractor by an online payment service like PayPal, credit card, or any other type of electronic payment, you don’t need to file a Form 1099-MISC reporting the payment to the IRS.”
“However, a Form 1099-K must be filed only if the payment company processes over $20,000 in gross payments to the contractor and the contractor had more than 200 transactions during the calendar year.”
“If a rental agent manages your rental property, the agent must comply with the reporting requirements explained in this section. The agent must also report to the IRS the gross (total) amount of rent collected each year, without subtracting fees, commissions, or other expenses.”
“The IRS imposes these requirements because it is very concerned that to avoid paying taxes, many ICs don’t report all the income they earn.”
“This requirement applies only to landlords whose rental activities qualify as a business for tax purposes. Landlords who are merely investors need not comply. However, most landlords qualify as business owners and it is to your advantage to do so.”
“The IRS can impose monetary penalties on landlords who fail to comply with the reporting requirements. The penalty is $500 for each 1099-MISC you intentionally fail to file. The penalty is less if the failure is not intentional, ranging from $50 to $250, depending on how quickly you fix the error by filing the 1099-MISC.”
“You need to obtain an unincorporated IC’s taxpayer ID number and file a 1099-MISC form with the IRS only if you pay the IC $600 or more during a year for rental-related services.”
“If an IC won’t give you his or her number or the IRS informs you that the number the IC gave you is incorrect, the IRS assumes the person isn’t going to voluntarily pay taxes. So it requires you to withhold taxes from the compensation you pay the IC and remit them to the IRS. This is called backup withholding. If you fail to backup withhold, the IRS will impose an assessment against you equal to 24% of what you paid the IC.”
“Backup withholding can be a bookkeeping burden for you. Fortunately, it’s very easy to avoid it. Have the IC fill out and sign IRS Form W-9, Request for Taxpayer Identification Number and Certification, and retain it in your files. (You can download it from the IRS website at http://www.irs.gov.)”
“To backup withhold, deposit with your bank 24% of the IC’s compensation every quarter. You must make these deposits separately from any payroll tax deposits you make for employees. Report the amounts withheld on IRS Form 945, Annual Return of Withheld Federal Income Tax. This is an annual return you must file by January 31 of the following year. (See the instructions to Form 945 for details.) You can download it from the IRS website at http://www.irs.gov.”
“You must file a 1099-MISC form for each IC you paid $600 or more by cash, check, or direct deposit during the year.”
“You can use accounting software such as QuickBooks or Xero, or online 1099 filing services such as tax1099.com, and many others.”
“The Form 1099-MISC contains five copies. These must be filed as follows:
• Copy A, the top copy, must be filed with the IRS no later than January 31 of the year after payment was made to the IC. If you don’t use the remaining two spaces for other ICs, leave those spaces blank. Don’t cut the page.
• Copy 1 must be filed with your state taxing authority if your state has a state income tax. The filing deadline may be January 31 or it could be February 28 (which was the deadline for the IRS and most states before 2017), but check with your state tax department to make sure. Your state may also have a specific transmittal form or cover letter you must obtain.
• Copy B and Copy 2 must be given to the worker no later than January 31 of the year after payment was made.
• Copy C is for you to retain for your files.”
“Under current law, the filing and ID requirements discussed above don’t apply to corporations.”
“There are two exceptions to the rule that you don’t have to file 1099-MISC forms for payments to corporations. You must report all payments of $600 or more you make to a doctor or lawyer who is incorporated.”
“The following states impose reporting requirements for those hiring independent contractors: California (if paid over $600 per year), Colorado, Connecticut (if paid over $5,000 per year), Iowa, Maine (if paid $2,500 or more), Massachusetts, Nebraska, New Jersey, New York, Ohio (if paid over $2,500 per year), South Carolina, Texas, and West Virginia. Find the state agency to contact at the U.S. Department of Health & Human Services website at http://www.acf.hhs.gov/css/resource/state-new-hire-reporting-contacts-and-program-requirements.”
“For example, a lawyer who handles an eviction or other legal matter for your rental business will usually seek reimbursement for expenses such as photocopying, court reporters, and travel. If this is the case, you may pay these reimbursements without concern about misclassification problems.”
“When you reimburse an IC for a business-related expense, you get the deduction for the expense, not the IC. You should not include the amount of the reimbursement on the 1099-MISC form you file with the IRS reporting how much you paid the IC, because the reimbursement is not considered income for the IC.”
“The employer and employee must each pay Social Security and Medicare (FICA) taxes. The employer must deduct the employee’s share from each wage payment. The FICA tax rate for both employer and employee is 7.65% of taxable wages (6.2% for the Social Security tax and 1.45% for the Medicare tax). The Social Security tax (OASDI) is subject to an annual taxable wage base limit ($128,400 for 2018). There is no wage base limit for the Medicare tax (HI).”
“The employer must also withhold federal income tax from each wage payment made to an employee. The amount to be withheld depends on the employee’s marital status and number of withholding allowances and exemptions claimed.”
“An employer must also pay federal unemployment tax on the employee’s wages up to an annual FUTA wage base ($7,000 in 2018). The FUTA tax rate is 6%, but employers obtain a 5.4% credit for timely payment of state unemployment taxes. Thus, the FUTA tax rate is generally 0.6%, or $42 per year per employee. This tax must be paid if an employer (1) pays at least $1,500 in total wages to employees in any three-month period, or (2) has at least one employee during any day of a week during 20 weeks in a calendar year (the 20 weeks need not be consecutive).”
“If your payroll is very small—less than $1,500 per calendar quarter— you probably won’t have to pay unemployment compensation taxes. In most states, you must pay state unemployment taxes for employees if you’re paying federal unemployment taxes. However, some states have stricter requirements.”
“California, Hawaii, New Jersey, New York, and Rhode Island have state disability insurance programs that provide employees with coverage for injuries or illnesses that are not related to work. Employers in these states must withhold their employees’ disability insurance contributions from their pay. Employers must also make their own contributions in Hawaii, New Jersey, and New York—these employer contributions are deductible.”
“Employers in all states (subject to some important exceptions) must pro­vide their employees with workers’ compensation insurance to cover work-related injuries. Workers’ compensation is not a payroll tax. Employers purchase a workers’ compensation policy from a private insurer or the state workers’ compensation fund. Your workers’ compensation insurance premiums are deductible as an insurance expense”
“Employers in California must withhold for parental leave. California recently became the first state to require paid family leave. Employers in California must withhold money from their employees’ paychecks (as part of the state’s disability insurance program) to fund this leave program. For more information on the program, go to http://www.edd.ca.gov/disability/paid_family_leave.htm.”
“Bookkeeping expenses are deductible. Figuring out how much to withhold, doing the necessary record keeping, and filling out the required forms can be complicated. If you have a computer, software programs such as QuickBooks can help with all the calculations and print out your employees’ checks and IRS forms. The cost of such software is deductible—you can deduct the full cost in one year using bonus depreciation or Section 179 or depreciate the cost over three years (see Chapter 5). You can also hire a bookkeeper or payroll tax service to do the work. Amounts you pay a bookkeeper or payroll tax service are deductible operating expenses.”
“Your child will have to pay tax on his or her salary only to the extent it exceeds the standard deduction amount for the year—$12,000 in 2018. Moreover, if your child is under the age of 18, you won’t have to withhold or pay any FICA (Social Security or
Medicare) tax on the salary (subject to a couple of exceptions).”
“Moreover, you need not pay federal unemployment (FUTA) taxes for services performed by your child who is under 21 years old.”
“However, these rules do not apply—and you must pay both FICA and FUTA—if you hire your child to work for:
• your partnership, unless all the partners are parents of the child, or
• your corporation (few small landlords are incorporated).”
“The real advantage of hiring your spouse is in the realm of employee benefits. You can provide your spouse with employee benefits such as health and accident insurance. You can take a tax deduction for the cost of the benefit and your spouse doesn’t have to declare the benefit as income, provided the IRS requirements are satisfied.”
“The IRS has accepted that a seven-year-old child may be an employee (see “Hardworking Seven-Year-Old Was Parents’ Employee,” below), but probably won’t believe that children younger than seven are performing any useful work for your
rental activity.”
“Instead of, or in addition to, hiring a resident manager, some landlords hire property management companies to manage their rentals. Such companies are often used by owners of large apartment complexes or absentee landlords who live far away from their rental property. Typically, you sign a contract spelling out the management company’s duties and fees. Such companies normally charge a fixed percentage—typically 5% to 10%—of the rent collected. Such fees are a deductible rental expense. Schedule E contains a line where they are deducted.”
“However, you need not pay or withhold any federal payroll taxes on the value of free lodging you provide a resident manager for a rental property if:
• the lodging is at your rental property—that is, the manager lives in a unit at your rental building
• the lodging is furnished for your convenience, and
• you require the manager to live there as a condition of employment—in other words, the manager has no choice in the matter. (I.R.C. § 119.)”
“Anne from the above example pays her resident manager John $800 per month, instead of reducing his rent by $800. She classifies him as her part-time employee and pays payroll tax on the salary she pays John. Anne, a single taxpayer, has $200,000 in taxable income. She’ll be able to deduct up to 25% of what she pays John—$2,400—as part of her pass- through tax deduction. She’ll also be able to deduct the full amount of the salary she pays as a rental expense deduction on Schedule E.”
“A casualty is damage, destruction, or loss of property due to an event that is sudden, unexpected, or unusual. Deductible casualty losses can result from many different causes, including, but not limited to:
• earthquakes
• fires
• floods
• government-ordered demolition or relocation of a building that is
unsafe to use because of a disaster
• landslides
• oil spills
• sonic booms
• storms, including hurricanes and tornadoes
• terrorist attacks
• theft
• vandalism, including vandalism to rental property by tenants, and
• volcanic eruptions.”
“There must be some external force involved in a casualty loss. Thus, you get no deduction if you simply lose property or it is damaged or destroyed due to your own negligence. However, a deductible casualty loss can be caused by another person’s carelessness or negligence. For example, you can deduct as a casualty loss sudden damage caused by a negligent contractor or workman.”
“Richard and Ruth Marx noticed that the roof to their house was leaking and hired a building contractor to repair it. Not long afterward, the roof leaked again during a storm, but this time the leak was much worse: It caused the drywall ceiling of the home to fall in, resulting in substantial damage to the interior. The tax court permitted the Marxes to claim a casualty loss for the damage, finding that the massive leaks were sudden and unexpected, were caused by the contractor’s negligence, and were independent of the preexisting minor leak. (Marx v. Comm’r., T.C. Memo 1991-598.)”
“You must always reduce your casualty losses by the amount of any insurance proceeds you receive, or reasonably expect to receive in the future.”
“You must also reduce your claimed loss by the amount of any of the following payments or services you receive or expect to receive:
• the cost of any repairs made by a tenant that you don’t pay for
• payments to you by the tenant to cover the cost of repairs
• any part of a federal disaster loan that is forgiven
• court awards for damage or theft loss, minus any attorneys’ fees or other expenses incurred to obtain the award, and
• the value of repairs, restoration, or cleanup services provided for
free by a relief agency such as the Red Cross.”
“If the property is only partly destroyed, your casualty loss deduction is
the lesser of:
• the decrease in the property’s fair market value, or
• its adjusted basis.
You must reduce both amounts by any insurance you receive or expect to receive. Unless you’ve owned the property for many years, the fair market value measure is usually less and is the one you must use.”
“If you’ve experienced a casualty loss, you can use an appraiser to determine the reduction in fair market value of your partly damagedproperty. However, this is often too expensive or impractical. Instead, most people use the cost of repairing the property to determine the fair market value reduction. You can use the cost of cleaning up or of making repairs after a casualty as a measure of the decrease in fair market value if:
• the repairs are actually made
• the repairs are necessary to bring the property back to its condition before the casualty
• the amount spent for repairs is not excessive
• the repairs take care of the damage only, and
• the value of the property after the repairs is not, due to the repairs, greater than its value before the casualty. (IRS Reg. § 1.165-7(a)(2)(ii).)”
“You must calculate casualty loss to rental property separately for each item that is damaged or destroyed. (IRS Reg. § 1.165-7(a)(2)(ii).) This may include a building, land improvements under the building, landscaping, and other land improvements apart from the building. However, you don’t need to separately deduct personal property items inside a rental property, such as stoves and refrigerators.”
“The cost of replacing or repairing property destroyed or damaged due to a casualty event ordinarily must be depreciated as an improvement—a restoration.”
“However, under the IRS repair regulations that took effect in 2014, a building owner is only required to depreciate restoration costs to the extent of the property’s adjusted basis immediately before the casualty event that damaged or destroyed the building. Any costs over this amount may be currently deducted if they constitute repairs under the IRS repair regulations discussed in Chapter 4.”
“Make sure you can document your losses. You’ll need to have:
• documents showing that you owned each asset you claimed was damaged, stolen, or destroyed—for example, a deed or receipt
• contracts or purchase receipts showing the original cost of the item, plus any improvements you made to it
• copies of your old tax returns showing all your regular and bonus depreciation and Section 179 deductions for the property, and
• evidence of the property’s fair market value, such as insurance records, an appraisal, or receipts for the cost of repairing it.”
“You can deduct dues paid to:
• apartment owner associations
• real estate boards
• local chambers of commerce and business leagues, and
• civic or public service organizations, such as a Rotary or Lions club.”
“Use other words to describe the deduction—for example, if you’re deducting membership dues for an apartment owners’ organization, list the expense as apartment
owners’ association membership fees.”
“To qualify for an education deduction, you must be able to show the education:
• maintains or improves skills required to be a successful landlord, or
• is required by law or regulation to maintain your professional status.”
“You cannot currently deduct education expenses you incur before your rental activity begins.”
“You may deduct the cost of gifts you make in the course of your rental business—for example, to thank or maintain goodwill with a vendor, tenant, or employee. This includes holiday gifts to tenants. However, the gift expense deduction is limited to $25 per person per year.”
“If you give a gift to a family member of a tenant, the gift is considered to be an indirect gift to the tenant and is subject to the $25 limit. Thus, you are limited to a single $25 gift deduction for each tenant and his or her entire family.”
“You can fully deduct your current year state and local property taxes on rental real property as an operating expense. However, if you prepay the next year’s property taxes, you may not deduct the prepaid amount until the following year.”
“When you buy your rental property, the property taxes due for the year must be divided between the buyer and seller according to how many days of the tax year each held ownership of the property. You’ll usually find information on this in the settlement statement you receive at the property closing.”
“When you purchase rental property, you must ordinarily pay state and local real estate transfer taxes. You cannot deduct these taxes in the year in which you paid them. Instead, add them to the basis of your property and depreciate them over time, as explained in Chapter 5.”
“If tenants fail to pay the rent owed you, can you deduct the loss? The short answer for the vast majority of small landlords is No.”
“Nor can you deduct unpaid rent as a casualty loss (see Chapter 14).”
“If you have deadbeat tenants, evict them as soon as possible and find a new tenant who will pay the rent. The legal fees to evict a tenant are deductible”
“You have a rental loss if all the deductions from a rental property you own exceed the annual rent and other money you receive from the property.”
“It is extremely common for landlords to have rental losses, especially in the first few years. Indeed, IRS statistics show that in one recent year, over half of the filed Schedule E forms reporting rental income and expenses showed a loss”
“If you have a rental loss for the year, you become subject to two sets of tax rules:
• the passive loss rules, and
• the at-risk rules.”
“The IRS has created a very useful, highly detailed guide to passive activity losses for its auditors called the Passive Activity Loss Audit Technique Guide. If you want more information on the passive loss rules, this is a good place to look. It’s available to the public at the IRS website at http://www.irs.gov.”
“Income or loss from (1) businesses in which you don’t materially participate, and (2) all rental properties you own. Under the rules, income and loss from rental activities are automatically passive, whether or not the landlord materially participates in the rental activity.”
“The contents of the passive bucket must always stay in that bucket. You cannot use passive losses to offset income in the other two buckets. Nor can you use passive income to offset losses from the other buckets.”
“Thus, a special exception—the $25,000 offset—was fashioned for them. It permits landlords to deduct up to $25,000 in rental losses from any other nonpassive income they earn during the year. The offset applies to all rental properties that a landlord owns—that is, you don’t get a separate $25,000 for each property you own. (I.R.C. § 469(i).)”
“The $25,000 offset is particularly important to small landlords. If your income isn’t much over $100,000 and your annual rental losses are less than $25,000, it can give you complete relief from the onerous PAL rules.”
“Landlords who qualify for the real estate professional exemption get extraordinary tax benefits unavailable to other people who earn income from rental property:
• First, real estate professionals can treat all of their losses from rental properties as active losses. This means they can deduct any rental activity losses they have for the year from all of their other income for the year, including active income and portfolio income. (I.R.C. § 469(c)(7).) However, starting in 2018, a maximum of $250,000 in losses can be deducted each year by singles, and $500,000 by married taxpayers (see “$250,000/$500,000 Annual Loss Limit,” below).
• Second, real estate professionals are not subject to the 3.8% Medicare tax on rental income that went into effect in 2013. This tax is imposed on all landlords with adjusted gross income over $200,000 for singles and $250,000 for married taxpayers filing jointly. Real estate professionals are specifically exempted from the new tax, provided that they materially participate in the rental activity and such activity qualifies as a business. (See Chapter 19 for a detailed discussion of this tax.)”
“To qualify as a real estate professional, you must:
• participate in one or more real property businesses
• “materially participate” in one or more of such businesses
• spend at least 51% of your annual work time at your real property business or businesses in which you materially participate, and
• spend at least 751 hours per year working at your real property businesses in which you materially participate. (I.R.C. § 469(c)(7).)”
“Most people who qualify for the exemption are engaged in one of the following activities:
• real estate rentals
• construction (contractor or builder)
• real estate brokerage work, or
• real property management.
You must be directly involved in one or more of these real property businesses to qualify for the exemption.”
“If you are an employee in someone else’s real property business, you do not qualify for the real estate professional exemption. You must own your own real property business or be a part owner of a business with more than a 5% ownership interest. If you work as an employee for a corporation, you must own more than 5% of your employer’ outstanding stock.”
“Courts have held that the time you spend organizing your personalrecords, preparing your taxes, paying bills, and reviewing monthly statements prepared by a real estate management company all constitute investor activities. (Barniskis v. Comm’r., T.C. Memo 1999-258.) Time you spend doing these tasks cannot be counted to pass the material participation tests.”
“Frank and Felicia are married and file a joint return. They own a four-unit apartment building they manage themselves. Felicia does most of the work, spending 400 hours a year dealing with tenants, showing vacant units, handling bookkeeping chores, and so forth. Frank does most of the repair work for the property, spending 120 hours a year on it. Together, Frank and Felicia spent 520 hours materially participating in their rental real estate activity—more than enough to pass the 500-hour test.”
“Suspended losses are unused passive losses from prior years. If you have substantial suspended losses from multiple rental properties, think carefully before filing an election to treat them as a single activity. The election could make it difficult for you to deduct your suspended losses when you sell your property.”
“You must determine anew each year whether you qualify for the real estate professional exemption by applying the three tests discussed above.”
“These unused passive losses are called suspended passive losses. They remain passive losses—they stay in your passive bucket. However, you may deduct them from income from your now-exempt rental property income. You can also deduct them from passive income in your passive bucket for the current year, or if you sell the exempt rental property”
“Unfortunately for people like Felix, the real estate professional exemption is mandatory, not optional. If you qualify, you are not allowed to deduct your losses from your exempt rental real property from passive income. The only way to avoid this is to make sure you don’t qualify for the exemption. This is not hard to do—for example, you can hire a management company to manage your rentals for you so you will not materially participate in them. Or, you could just make sure you work less than 751 hours per year in real estate activities.”
“The real estate professional exemption has been receiving much attention from the IRS lately. Tax pros report that many of their real estate professional clients are being audited on this issue. This attention is likely to increase in future years because even more landlords seek to qualify for the real estate professional exemption in order to avoid the Net Investment Income tax (see Chapter 18). The best way to protect yourself from the IRS is to keep adequate records.”
“Finally, you may deduct your suspended passive losses from the profit you earn when you sell your rental property. To deduct your suspended losses upon sale, you must:
• sell ‘substantially all’ of your interest in the rental activity
• sell to an unrelated party—that is, a person other than your spouse, brothers, sisters, ancestors (parents, grandparents), lineal descendants (children, grandchildren), or a corporation or partnership in which you own more than 50% (100% of your ownership interest), and
• the sale must be a taxable event—that is, you must recognize income or loss for tax purposes; this means tax-deferred Section 1031 exchanges don’t count, except to the extent you recognize any taxable income. (I.R.C. § 469(g).)”
“You may also have to complete IRS Form 8582, Passive Activity Loss Limitations. This complex tax form requires you to list your current and suspended losses for each rental property, and any other passive activities you are engaged in.”
“If your passive income exceeds your passive losses, you’ll have to add it to your taxable income for the year. It will be subject not only to regular income tax, but to the new 3.8% Net Investment Income tax if your adjusted gross income exceeds $200,000 if you’re single and $250,000 if you’re married and filing jointly. (See Chapter 19.)”
“Starting in 2018 and continuing through 2025, married taxpayers filing jointly may deduct no more than $500,000 per year in business losses, including rental business losses, over their rental and other business income. Single taxpayers may deduct no more then $250,000. In other words, a landlord may deduct losses equal to his or her total income from the rental business and any other businesses and an additional $250,000 or $500,000. The effect is that no more than $250,000/$500,000 in rental losses can be deducted from nonrental income in any one year during 2018 through 2025.”
“Excess business losses are calculated as follows:
• add all your income for the year from all your businesses, rental and nonrental, plus wage income
• add to this total $250,000 if single, $500,000 if married filing jointly—this is the total amount of losses you may deduct
• subtract this amount from your total rental and other business losses for the year—any positive number is an excess business loss.”
“You usually don’t have to worry about the at-risk rules unless you obtain seller financing or a loan from a relative at unusually favorable terms.”
“In the case of rental real estate activities, you are at risk for:
• the total amount of cash you invest—for example, your cash down payment to purchase a rental property
• the adjusted basis of property you contribute to the activity, and
• most loans you obtain to purchase or otherwise operate your rental activity. (I.R.C. § 465.)”
“A nonrecourse loan is a loan for which you are not personally liable. The lender’s only recourse if you fail to pay is to foreclose on the property and take over ownership.”
“A loan is a recourse loan if you are personally liable if it is not repaid on time—that is, the lender can not only foreclose on the property, but also obtain a deficiency judgment against you for the difference between the property’s value at foreclosure and the amount you owe.”
“Stuart buys a rental home by making a $20,000 down payment and borrowing $180,000 from a bank. He is at risk for $200,000. This year, he loses $10,000 on the property. This is far less than his at-risk amount, so it doesn’t affect his ability to deduct the loss.”
“Assume that, instead of using conventional financing as in the example above, Stuart purchases his home using creative financing. He gives the seller $1,000 cash and a car with an adjusted basis of $4,000. He borrows the remaining $195,000 from the seller, agreeing to a nonrecourse loan. Now, Stuart is at risk for only $5,000, because the $195,000 loan is not included in his at-risk amount. If he loses $10,000 on his property this year, he may only deduct $5,000. The remaining $5,000 loss is suspended and must be carried over to a future year when he has a sufficient amount at risk.”
“The at-risk rules are applied before the passive loss rules.”
“If the at-risk rules prevent you from deducting a loss, you’ll have to fill out IRS Form 6198, At-Risk Limitations.”
“If you purchase a rental property with seller financing, you need to carefully consider the effect of the at-risk rules. You might consider avoiding or limiting their application by obtaining at least some conventional financing, or by borrowing less by making a larger down payment.”
“Refer to IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, for more information. You can download it from the IRS website at http://www.irs.gov, or obtain a paper copy by calling the IRS at 800-TAX-FORM.”
“If you own more than one rental property, you must separately keep track of your income and expenses for each property—don’t mix them together. One reason for this inconvenient rule is that the IRS requires that you separately list your income and expenses for each property on your Schedule E. Also, you’ll never know how much money you’re making or losing on each property unless you separately track your income and expenses.”
“A list and comparison of most available accounting software packages and online subscription services can be found at http://en.wikipedia.org/wiki/Comparison_of_accounting_software.”
“There are many software applications designed specifically for rental property management including Quicken Rental Property Manager, Buildium, Yardi, and VMS. These can be particularly helpful if you own more than ten units. In addition, cozy.co has a free online landlord expense tracking app. These applications have features designed specifically with landlords in mind. For example, they can:
• identify tax-deductible rental property expenses
• track income and expenses by property
• create a Schedule E report to save you time on taxes
• show which rents have been paid
• show how rental properties are doing, and
• store lease terms, rental rates, and security deposits for each tenant.”
“If you have employees—such as a resident manager—you must create and keep a number of records, including payroll tax records, withholding records, and employment tax returns. And you must keep these records for four years. For detailed information, see IRS Publication 15, Circular E, Employer’s Tax Guide. You can get a free copy by calling the IRS at 800-TAX-FORM, by calling or visiting your local IRS office, or by downloading it from the IRS website at http://www.irs.gov.”
“Some states require landlords to use a separate account for tenants’ security deposits. Check your state’s laws, available online at http://www.nolo.com and in Every Landlord’s Legal Guide, by Marcia Stewart, Ralph Warner, and Janet Portman (Nolo). If your state requires a separate account, you may need to establish two accounts for your business—one for general rental activity, and one for security deposits.”
“For example, suppose Stuart owns three rental houses. He pays $300 for a new lawn mower he will use for all three houses. He allocates $100 of the cost to each rental house.”
“If your rental properties vary greatly in size, a more reasonable way to allocate expenses is by the gross income they generate.”
“Any interest you earn on your tenants’ security deposits is also rental
income, unless state or local law requires you to repay it to your tenants
on a yearly basis or when they move out.”
“Thus, for example, you can record the five facts with:
• a receipt, credit card slip, or similar document alone
• a receipt combined with an appointment book entry, or
• an appointment book entry alone (for expenses less than $75).”
“Partnerships, limited partner­ ships, multimember LLCs, and S corporations file IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, to report rental income and deductions. This form is very similar to Schedule E. The individual LLC or partnership members (or S corporation shareholders) are each given a Schedule K-1 by the entity reporting their individual shares of annual income or loss from the rental activity. The individuals then list this amount on Part II of Schedule E, on page 2. However, a single-member LLC is ordinarily not treated as a separate entity for federal income tax purposes. Thus, if you are the sole member of an LLC, you normally file Schedule E, Part I.”
“Do not file Schedule E if your rental activity is classified as a regular business instead of a rental activity. This will be the case if you provide substantial services to your guests, such as maid service and food service. (See Chapter 1). If you are an individual owner or owner of a one-person LLC, file Schedule C, Profit or Loss From Business (Sole Proprietorship).”
“If your rentals earn a profit, you became subject to the Net Investment Income tax (“NII tax” for short; also called the Medicare contribution tax).”
“If you own real estate rentals through a pass-through entity, such as a limited liability company, partnership, or S corporation, the NII tax rules still apply to you at the individual level.”
“You’ll be subject to the NII tax only if your AGI for the year exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly (the threshold is $125,000 for married couples filing separately). If you add up all of your income from every source, and the total is less than the applicable $200,000/$250,000 threshold, you will not be subject to this tax.”
“Even if your AGI exceeds the $200,000/$250,000 threshold, you’ll be subject to the NII tax only if you have ‘net investment income.'”
“Net investment income consists of:
• net rental income (rents minus expenses)
• income from investments, including interest, dividends, and annuities
• income from any business in which you don’t materially participate
(aren’t active in running), including real estate limited partnerships and other real estate investment businesses, and
• net capital gains (gains less capital losses) you earn upon the sale of property that is not part of an active business, including rental property, stocks and bonds, and mutual funds.
Net investment income does not include:
• income from a business in which you materially participate (actively run), any self-employment income, or wages you earn from employment (this exception does not apply to rental activities, even if you materially participate in them; the only exception is if you’re a real estate professional; see below)
• tax-exempt income such as income from tax-exempt bonds, the amount of profit excluded from tax when you sell your principal residence ($250,000 for singles, $500,000 for married couples filing jointly), or income earned from renting your home for no more than 14 days during the year
• withdrawals from retirement plans such as traditional or Roth IRAs, 401(k)s, or payouts from traditional defined-benefit pension plans, or
• life insurance proceeds, veterans benefits, Social Security benefits, alimony, or unemployment benefits.”
“The NII tax is a flat 3.8% tax. However, it is not imposed on your total AGI or investment income. Instead, it is assessed only on the portion of your income determined by a formula: The tax must paid on the lesser of (1) the taxpayer’s net investment income, or (2) the amount that the taxpayer’s adjusted gross income (AGI) exceeds the applicable threshold: $200,000 for single taxpayers, and $250,000 for married filing jointly.”
“You only have to pay the NII tax on income over the $200,000/$250,000 threshold. Thus, for those at the lower end of the AGI threshold, the NII tax is fairly small. For example, a single taxpayer with a $201,000 AGI, including $50,000 in rental income, would onlypay the 3.8% tax on $1,000.”
“Ludmilla, a single taxpayer, earns $200,000 in gross rents and has $100,000 in expenses, ending up with $100,000 in net rental income that must be included in her AGI. She also has $250,000 in employee income. Her AGI is $350,000—$150,000 over the $200,000 NII tax threshold. She must pay the 3.8% NII tax on the lesser of $150,000 or $100,000. Since $100,000 is less, she owes $3,800 in NII tax for the year that she must pay along with her regular income taxes.”
“Many people who earn their living from landlording will be exempt from the tax because they’ll qualify for a special exemption from the tax for real estate professionals. If you qualify for this exemption, you need not include your rental income or gains in your net investment income, no matter how large. You must satisfy three tests to be eligible for this exemption:
• you must be a real estate professional
• you must materially participate in the rental activity, and
• your rental activity must qualify as a business for tax purposes.”
“Obviously, the way to avoid the NII tax is to keep your AGI for the year below the $200,000/$250,000 threshold or have no net investment income. There are many ways to do this:
• increase rental losses you can deduct from your rental income
• avoid a large single-year gain when you sell rental property by using installment agreements which spread your payment over many years
• avoid a large single-year gain when you sell rental property by using a like-kind exchange that can defer tax on your gain indefinitely
• don’t sell your rental property—when you die your heirs can inherit it tax-free
• convert as much income as possible to tax-exempt income that
doesn’t increase your AGI or net investment income—for example, take as many tax-free employee fringe benefits from your employer as you can instead of salary
• take stock options in place of some of your salary—when you exercise an ISO, you don’t have income for NII tax or income tax purposes (however, you do have income for alternative minimum tax purposes)
• increase above-the-line deductions on your Form 1040—for example, make tax-deductible contributions to your 401(k), traditional IRA, or other qualified retirement plan; if you’re over 70.5 years of age, donate an IRA of up to $100,000 to charity, and
• harvest capital losses to deduct from your gains.”

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