Looking to invest in real estate? The many tax loopholes available can make this an attractive source of income—but first-time property owners may feel uncertain about taking advantage of these tax breaks. Rest assured that legitimate loopholes were intentionally created by the government to promote property ownership. By enticing taxpayers with tax benefits, more people are able and willing to make this sizable financial investment.
How can owning real estate turn into income? The four main ways are:
- Rental income
- Appreciation on the property itself (an increase in overall value over time)
- Appreciation of inventory
- Short-term rentals
With the popularity of sites like Airbnb and Vrbo, short-term rentals in particular have become a more common secondary income source. Homeowners may already have an additional unit on their property—say a converted garage apartment or “mother-in-law suite” as they are sometimes called. These spaces will receive different tax treatment than your typical rental of a full house or apartment.
The major tax break that makes short-term rentals so attractive is known as the “Augusta Rule.” This rule says that if you rent out your primary or secondary residence for fewer than 15 days, then you don’t have to report the income. In other words, you can rent out a property for 14 days within a single tax year and pay no tax on the income you received from that rental.
However, this perk does come with some limitations. For instance, any expenses that are directly associated with the rental—like advertising, commission, or cleaning—are not deductible. This restriction makes sense when you consider that the owner does not have to claim the income on their tax return. Also, keep in mind that those 14 days are cumulative if you have both a primary and a secondary residence you sometimes rent out—you don’t receive 14 days for one property and then an extra 14 days for the second one.
The rules also differ if the property is an investment property versus a personally-owned property that is rented out occasionally. For personal property, you can only deduct rental expenses to the extent of your rental income. You will also be subject to passive activity rules, which say that these expenses are only deductible to the extent that you have passive income. So if the expenses you are trying to claim exceed your earnings, those cannot be deducted. However, these losses can be suspended until a future tax year when you have enough income to claim these deductions.
What happens if you go a day over the Augusta rule’s 14-day maximum? You will have to report the rental income you earned, even if you only rented out the space for 15 days. On the positive side, you may now be able to deduct rental expenses, such as repairs, utilities, depreciation, or insurance. What you can deduct depends on the amount of personal use versus rental use of the property. You will not be allowed to deduct any interest that’s attributable to the personal use of the home. However, say a portion of your property tax can be attributed to the rental use of the home—that amount would not be subject to the usual $10,000 limit on state and local tax deductions. Allocating property tax to the rental could therefore result in a higher tax deduction.
If you do have to report your rental income, fortunately, you will not typically have to pay self-employment tax. This will depend on how you are earning income on that property, but collecting rent alone would not usually be considered a type of self-employment. However, if you are a real estate broker who is paid commission every time you represent someone in buying or selling a home, the IRS will consider rental income to be “earned income,” and you will have to pay self-employment taxes. The same is true if the sale of a property as inventory is part of someone’s business as a dealer or developer.
Lastly, depreciation can be a major tax planning tool. Depreciation is a portion of what was paid for a property—for tax purposes, you are essentially allowed to deduct the cost slowly over time and therefore lower your tax bill. To do so, you will need to keep track of the property’s tax basis, or the amount of capital you have invested. If the property qualifies for depreciation, knowing the tax basis helps you to calculate depreciation accurately and hopefully gain a bigger tax write-off.
For expert assistance in navigating the tax benefits for property rentals, connect with a Certified Tax Planner today.