Once you take the step of converting a residence to a rental property, the tax planning process is far from over! Wise investors also need to consider the tax implications of generating income from a rental property and learn about the potential tax breaks.
Real estate rentals can either be long-term or short-term. With long-term rentals, you are entitled to take the traditional real estate deductions—these might be related to mortgage interest, property taxes, insurance, and property management fees. A second category could be called “planning deductions” and can include hiring your children, employee benefits, and cost segregation (if it applies). If you hold onto the property for more than a year, it may also qualify for capital gain treatment, which potentially means you will see a much lower tax rate when the property is sold.
One financial planning strategy is to place your property into an entity—a legal business organization like an LLC. With rental properties, the main role of an entity is asset protection. If you own a rental property personally, you 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 your personally-owned assets including savings accounts, your primary residence, your vehicle, and similar possessions. Using an entity puts a barrier between what you own personally and what the entity owns. Imagine that the entity creates a vault that now holds your property—whatever is in the vault is at risk, but whatever is outside the vault is not. Also, if you own more than one property, these will also be at risk if the properties are held in the same entity.
Secondly, long-term rentals could be eligible for the qualified business income (QBI) deduction, described in Section 199A. To qualify, the rental property needs to rise to the level of a trade or business activity. A significant new safe harbor rule was introduced in 2019, which said that if your property is being rented for a for-profit motive and you devote 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 you use 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 QBI deduction. Also, on long-term rental properties, passive activity loss rules do apply. This means that if your property experiences an overall loss of income one year, because it is considered passive income, that loss can only be deducted if you have other passive income to offset it. So if your property generates an overall loss of $10,000, you will need $10,000 from other passive income sources (such as other rental properties or a small business you do not materially participate in) to deduct the full loss. If not, the loss will be carried forward each year until you have the passive income to offset it or until you dispose of the rental activity.
If you are 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 number is seven days or less, then you qualify as a short-term rental.
Investors looking to earn income from a rental property might miss out on tax benefits or set themselves up for financial complications by diving in without a tax plan. For tailored advice on tax planning for rental properties and other real estate investments, reach out to a Certified Tax Planner today.
