In a recent blog, we discussed the tax implications of converting a residence to a rental property. Once that rental property begins generating income, what else does a taxpayer need to consider for effective tax planning?
First, real estate rentals classify as either long-term or short-term rentals. Long-term rentals typically qualify for traditional real estate tax deductions from mortgage interest, property taxes, insurance, and property management fees. “Planning deductions” may also be available based on factors like hiring your children, employee benefits, and cost segregation (if applicable). If the owner holds onto the property for more than a year, it qualifies for capital gain treatment, which potentially means a much lower tax rate when the property is sold.
One financial planning strategy is to use an entity for asset protection and separation of activities. When a taxpayer owns a rental property personally, they are open to litigation on that property or liability that arises from that property. For instance, if a tenant slips and falls, they could sue for payment based on personally-owned assets including savings accounts, primary residence, vehicles, and similar possessions. Using an entity puts a barrier between what personally-owned assets and what the entity owns. Imagine the entity as a vault containing the property—whatever is in the vault is at risk, but whatever is outside the vault is not. Consider also that if the owner holds more than one property, these will also be at risk if the properties are held in the same entity.
Secondly, long-term rentals may qualify for Section 199A—the qualified business income (QBI) deduction. A QBI deduction may be available if the rental property rises to the level of a trade or business activity. In 2019, a revenue procedure was issued that established a new safe harbor rule for this deduction. The new rule said that if a property is being rented for a for-profit motive and the owner devotes at least 250 hours per year to the rental property (or group of rentals), the income from that property may qualify for the deduction. The income can even qualify if the owner uses a property manager, and any time spent supervising that property manager can count toward the 250 hours for the safe harbor test.
Property owners should note that triple net leases—where the tenant agrees to pay all property expenses such as real estate taxes, building insurance, and maintenance—do not qualify for the 199-A deduction. Also, on long-term rental properties, passive activity loss rules apply. When a rental property experiences an overall loss, that loss is passive by definition and can only be deducted when the owner has passive income to offset against it. Otherwise, the loss will be carried forward until there is sufficient passive income or a complete disposal of that activity. If the owner chooses to dispose of the rental, the suspended loss can then be deducted against other kinds of income.
If an investor is dealing with a suspended passive loss, a short-term rental can provide a possible workaround. Section 469, on passive activity losses and credits, says that a rental qualifies as a business when the average rental time is seven days or less. If the rental is a business, it is not subject to the passive activity loss suspension rules. To calculate the average, take the total number of days that the property was rented during one calendar year and divide that number by the total number of stays. If that final quotient is seven days or less, then the property qualifies as a short-term rental.
New and even practiced real estate investors may struggle to identify available tax deductions and avoid costly mistakes without the assistance of an expert. Increase your knowledge on tax planning for rental properties and other real estate investments by signing up to become a Certified Tax Planner.
