Rental property used to be a superstar of tax shelters, one of America’s favorite tax breaks.
Under tax reform, the once-juicy writeoffs for mortgage interest, repairs, depreciation and other rental expenses are not nearly as alluring. In many cases, losses on rentals resulting from those expenses can no longer be written off dollar for dollar against income from wages and salaries. Depreciation allowances also are less generous.
The complex new rules are “quite a shocker” for many people in Southern California and elsewhere who bought rental real estate over the years thinking that they could fully write off rental losses against income from salaries, said Stephanie Enright, a Torrance financial planner.
As a result, rental real estate must increasingly be judged on its profit potential rather than on its tax benefits. Many owners who bought properties for their tax benefits are selling them. Some are trying to circumvent the new limitations by taking out home equity loans on their primary residences--where mortgage interest is fully deductible under most cases. They then use the loan proceeds to reduce debt on their rental properties--where interest may not be fully deductible.
Here is a primer on the key changes in tax reform affecting rental income:
Question: What is the key change under tax reform?
Answer: Losses generated from such rental expenses as mortgage interest, repairs and depreciation are now considered to be “passive” losses, deductible only against so-called passive income, with some very important exceptions. Rental losses are considered passive even if you actively manage your property. Before, you could write off rental losses against income from any source.
Q: What qualifies as passive income?
A: Rental income may be the best source. Also qualifying is income from limited partnerships. However, income from salaries, dividends and interest do not qualify as passive income.
If your income from rentals exceeds your expenses, you need not worry about the new rules. Your expenses will be fully offset and thus you will not have a rental loss.
Q: What are the exceptions under which I can still deduct rental losses against ordinary income from wages and salaries?
A: There are two major exceptions.
Exception No. 1 applies if you own at least 10% of the property, actively manage it and have an adjusted gross income of $100,000 or less (figured before you subtract rental losses or other passive losses). In that case, you can deduct rental losses of up to $25,000 from ordinary income.
If your adjusted gross income is between $100,000 and $150,000, the $25,000 writeoff allowance is reduced by 50 cents for every $1 of income over $100,000. So, for example, if your adjusted gross income is $110,000, you lose $5,000 of that allowance and can deduct only $20,000 of your rental losses against ordinary income.
(Note: That $100,000 limit applies both to single taxpayers and to married taxpayers filing jointly. Married taxpayers filing separately must cut the limits in half.
(Another note: Unfortunately, the IRS has not yet defined what constitutes being an active manager to qualify for the $25,000 allowance. However, many accountants believe that to qualify you must approve tenants, establish rental terms or approve expenditures. You can use a rental agent to administer these items as long as you make the decisions, they say.
(Still another note: If you own several rental properties, you cannot deduct $25,000 from your ordinary income for each rental property. The $25,000 limit applies to all of your rental properties combined.
(Still another note: Under newly issued IRS rules, your rental activity may be defined as a business, and thus its losses may not be eligible for the $25,000 allowance. One circumstance under which that would occur is if the average rental period is seven days or less each time you rent out your property--as is often the case with motels, hotels and vacation condos--and you don’t stay in the property more than 14 days or 10% of the time you rent it. However, if you put in more than 500 hours a year working on the property--or enough time to do substantially all that can be done on it--then its losses are considered active and thus can shelter ordinary income from wages and salaries.)
Exception No. 2 applies if you purchased your rental property on or before Oct. 22, 1986, and placed it into rental service by Dec. 31, 1986. Under a phase-in rule, you can write off 65% of your rental losses against ordinary income for 1987 taxes. The remaining 35% must be carried forward into future years and deducted only against passive income.
Under this phase-in rule, the amount of losses you can write off against ordinary income falls to 40% for 1988 taxes, 20% for 1989, 10% for 1990 and zero after that.
These phase-in percentages, however, are not available for those under the alternative minimum tax, according to William M. Ruddy, tax partner in the Los Angeles office of Ernst & Whinney, a major accounting firm.
Q: Can I qualify for both exceptions?
A: Yes. If you bought your rental property on or before Oct. 22, 1986, and have adjusted gross income of less than $150,000, you can use both exceptions.
For example, let’s suppose you bought your property in 1985 and have adjusted gross income of $95,000. You have $40,000 in rental expenses and $5,000 in passive income from rents, giving you a net loss of $35,000. You can then use $25,000 of that loss to reduce your taxable ordinary income, such as salaries, leaving you with $10,000 in unused losses. You can then also use 65% of that, or $6,500, to write off against ordinary income. So only $3,500 of your losses are left over, carried forward into future years.
Q: What’s involved in carrying forward unused rental losses?
A: You can carry unused passive losses forward indefinitely, deductible in the future against passive income.
Or, if you sell the property, you may apply unused passive losses against any capital gain you realize on the sale of the property. Any other unused losses from that particular property can then by applied against other income, passive or otherwise, in the year of the sale. This rule applies only if you sell to a party not related to you in a fully taxable transaction, said Ruddy of Ernst & Whinney.
Q: What qualifies as rental expenses?
A: Mortgage interest; property taxes; operating expenses, such as repairs and maintenance; insurance premiums; expenses for finding and screening tenants; commissions for collecting rents; cost of traveling to and from the property; cost of advertising for rentals, and depreciation.
Q: What are the new rules for depreciation?
A: If you started renting out your property on or before Dec. 31, 1986, the old rules still apply. They allow you to depreciate your property over 19 years, with the option of using an accelerated method that would give you higher writeoffs up front.
But, under the new rules, you must depreciate residential rental real estate over 27.5 years (and for non-residential property, it’s 31.5 years). That means you get a smaller writeoff each year. Also, now you cannot use accelerated depreciation. Instead, you must use straight-line depreciation, which means you must write off the same amount each year.
Q: Could I gain by classifying my rental property as a second home?
A: Possibly. Second homes are eligible for the same deductions as primary residences, which means that in most cases you can fully deduct mortgage interest and property taxes. Interest expense on rental homes, on the other hand, has limited deductibility.
Another benefit of second homes: If you rent them out for 14 days or less per year, the rental income is tax free.
However, expenses such as repairs and depreciation are generally not deductible for second homes.
You can classify your rental as a second home by staying in it for more than 14 days a year, or more than 10% of the time you rent it. So if you rent it for 250 days and use it for more than 25 days, it would be classified as a second home.
However, if you use your property partially for rentals and partially for personal use, you will be subject to a whole set of complex rules that require you to allocate expenses on a proportional basis to rental and personal uses, with different tax treatments for each.
You should calculate your taxes under each scenario to determine under what circumstances it would be better to classify your rental property as a second home, Ernst & Whinney’s Ruddy suggests.
Q: How can I get around the limits on deductions on my rental losses?
A: Stan Ross, co-managing partner of Kenneth Leventhal & Co., a Los Angeles accounting firm, offers several suggestions:
- Reduce your rental losses. One way to do this is by shifting mortgage debt from your rental property to your primary or second home. Take out a home equity loan or second mortgage on your primary or second residence, and use the proceeds to pay down part of your rental debt.
- Sell part of your rental property, perhaps through a time-share arrangement. You can use unused rental losses to offset any capital gain from the sale.
- Swap for another rental property of equal value in which the losses are likely to be lower.
- Boost your passive income by trying to rent out the property more. Or find other sources of passive income, such as limited partnerships in real estate, oil and gas, or equipment leasing where you have little or no active participation.