Steven L. Nartker

Investing in residential rental properties raises various tax issues that can be somewhat confusing, especially if you are not a real estate professional. Some of the more important issues rental property investors will want to be aware of are discussed below.

Rental Losses

Currently, the owner of a residential rental property may depreciate the building over a 27½-year period. For example, a property acquired for $200,000 could generate a depreciation deduction of as much as $7,273 per year. Additional depreciation deductions may be available for furnishings provided with the rental property. When large depreciation deductions are added to other rental expenses, it’s not uncommon for a rental activity to generate a tax loss. The question then becomes whether that loss is deductible.

$25,000 Loss Limitation

The tax law generally treats real estate rental losses as “passive” and therefore available only for offsetting any passive income an individual taxpayer may have. However, a limited exception is available where an individual owns at least a 10% ownership interest in the property and “actively participates” in the rental activity. In this situation, up to $25,000 of passive rental losses may be used to offset nonpassive income, such as wages from a job. (The $25,000 loss allowance phases out with modified adjusted gross income between $100,000 and $150,000.) Passive activity losses that are not currently deductible are carried forward to future tax years.

What constitutes active participation? The IRS describes it as “participating in making management decisions or arranging for others to provide services (such as repairs) in a significant and bona fide sense.” Examples provided by the IRS of management decisions include approving tenants and deciding on rental terms.

Selling the Property

Gain realized on the sale of residential rental property held for investment is generally taxed as capital gain. If the gain is long term, it is taxed at a favorable capital gains rate. However, the IRS requires that any allowable depreciation be “recaptured” and taxed at a 25% maximum rate rather than the 15% (or 20%) long-term capital gains rate that generally applies.

Exclusion of Gain

The tax law has a generous exclusion for gain from the sale of a principal residence. Generally, taxpayers may exclude up to $250,000 ($500,000 for certain joint filers) of their gain, provided they have owned and used the property as a principal residence for two out of the five years preceding the sale.

After the exclusion was enacted, some landlords moved into their properties and established the properties as their principal residences to make use of the home sale exclusion. However, Congress subsequently changed the rules for sales completed after 2008. Under the current rules, gain will be taxable to the extent the property was not used as the taxpayer’s principal residence after 2008.

This rule can be a trap for the unwary. For example, a couple might buy a vacation home and rent the property out to help finance the purchase. Later, upon retirement, the couple may turn the vacation home into their principal residence. If the home is subsequently sold, all or part of any gain on the sale could be taxable under the above-described rule.

To learn more about taxes and rental property, give us a call today. Our staff of professionals are always happy to help.

Learn How to Increase Your Bottom Line with Early Year-End Tax Planning

Although tax season might seem as if it’s a long way off, tax planning in the months before year-end allows you to take advantage of strategies that might help reduce your income-tax obligation. Reviewing commonly used strategies will help you identify those that might be useful to you.

Capitalize on Winners

Your investments are a good starting point for implementing tax-saving strategies. You can benefit from favorable tax rates on long-term capital gains by selling and taking profits on appreciated securities you’ve held longer than one year. Long-term gain is currently taxed at a maximum rate of 15% for most taxpayers and 20% for taxpayers in the top regular tax bracket (39.6%).

Cut Your Tax Bite with Losers

Investments that have lost value and have consistently underperformed a benchmark over time may be perfect sell candidates, particularly if you’re not confident of a turnaround. By selling your losers, you can use your losses to balance out gains on appreciated securities you’ve sold. Capital losses are fully deductible to offset capital gains and up to $3,000 of ordinary income each year ($1,500 if married filing separately). Any losses that you can’t deduct for 2016 can be carried over for deduction in future years, subject to the same limits.

Don’t make taxes your only reason for selling an investment. Many different factors should go into the decision to sell securities, including how the sale of a specific investment would affect your overall portfolio.

Curb Surtax Exposure

The 3.8% surtax on net investment income is a relatively new wrinkle for higher income taxpayers. The surtax comes into play when an individual filer’s modified adjusted gross income (AGI) is more than $200,000 ($250,000 on a joint return or $125,000 if married filing separately). The surtax applies to the lesser of net investment income or the amount by which modified AGI exceeds the threshold. For purposes of the surtax, net investment income includes taxable interest, dividends, annuities, royalties, rents, net capital gain, and income from passive trade or business activities. The surtax doesn’t apply to municipal bond interest or distributions from tax-deferred retirement plans.

A number of planning moves are available that may help reduce your exposure to the surtax. These include:

• Maximizing your contributions to your employer’s qualified retirement plan. For 2016, you can contribute up to $18,000, plus an additional catch-up amount of $6,000 if you’re age 50 or older and your plan allows, to a 401(k) or similar plan. Pretax contributions to a tax-qualified plan reduce your taxable income.
• Contributing to a traditional individual retirement account (IRA). Contributions are tax deductible if neither you nor your spouse actively participates in an employer-sponsored retirement plan. For 2016, the contribution limit is $5,500 ($6,500 with catch-up).
• Investing in tax-free municipal bonds. Be cautious, however, about investing in private activity municipal bonds, which can increase your exposure to the alternative minimum tax (AMT).
• Deferring capital gains through the use of installment sales. The installment method lets you defer taxes on the sale of certain property by recognizing profit over more than one tax year.

Thinking about installing a renewable energy system in your residence? Uncle Sam offers individual taxpayers a federal income-tax credit equal to 30% of the cost of qualified residential energy-efficient property (REEP).

What Systems Can Qualify?

Credit-eligible property includes:

• Solar electric

• Solar water heating

• Geothermal heat pump (uses ground or ground water as a thermal energy source for heating or cooling)

• Small wind energy (generates electricity using a wind turbine)

• Fuel cell (generates electricity from hydrogen and oxygen through an electrochemical process)

The credit covers the cost of both the equipment and its installation, including labor and any piping or wiring necessary to connect it to your home.

The system must meet specified standards for energy efficiency. You should obtain a certification from the manufacturer that the component you are purchasing meets the relevant requirements for the REEP credit. Note that the manufacturer’s certification is different from the U.S. Department of Energy’s Energy Star label; not all products with the Energy Star label meet the credit requirements.

When available, the tax credit is quite generous. For example, let’s say you spend $6,000 in 2015 on a home solar water heating system that meets all requirements for the REEP tax credit. After considering the $1,800 credit ($6,000 × 30%), the system costs you only $4,200.

Restrictions

The home you are installing the equipment in must be located in the United States and you must use it as your residence. The credit is not available for equipment used to heat a swimming pool or hot tub.

Solar, geothermal, or wind energy property can qualify for the credit whether it is installed in your principal residence or another residence. The credit for fuel cell property is limited to equipment installed in your principal residence.

As for cost, the tax law generally places no dollar limits on the credit. However, there is an exception for fuel cell property: The maximum credit is $500 for each 0.5 kilowatt of capacity.

Some states and public utilities offer incentives to encourage the purchase of energy-efficient property. Certain types of incentives may require an adjustment to your purchase price or cost for credit calculation purposes.

Connect with our team today for all the latest and most current tax rules and regulations.