Rent Out Your House

Who says Commies don't get capitalism?  This week Russian punk rock group, Pussy Riot, was back in the news.  They may not be good at music, but they are great at branding.  If they were named Ruptured Spleen Riot, would we have heard about them?

So you want to move to a bigger house but can't, because your current house is so far underwater the zip code was changed to Atlantis.  How will you ever manage to fit four wives, ten children, and fifteen cats into your three bedroom townhouse?  You're in luck, because I have the answer.  It might not be a good answer, but you aren't paying anything for this advice.  So you'll get what you pay for.

There are three things to know about taxes on rentals before you advertise your house on Craigslist: 1. How your rental will affect your tax situation, 2. What you can deduct, and 3. How you report the income and expense on your tax returns.  Let's start out with #1.

You might reasonably think renting out your house puts you in the rental business, not really from an IRS perspective.  Unless you are a real estate professional, meaning a real estate agent or involved in a real estate trade, your rental is considered a passive activity.  With a normal trade or business, if you make a profit, you pay taxes on the profit.  If you incur a loss, you can deduct the loss against other income such as wages.  This isn't true with rental real estate.

With rental real estate, you pay taxes on any profit you earn, but you do not get to deduct any losses you suffer unless your adjusted gross income is less than $100K.  If your income is less than $100K, you can deduct up to $25K in rental losses.  If your income is between $100K and $150K, you get a prorated portion of the $25K.  If your income exceeds $150K, you get no immediate deduction at all.

You don't lose any rental losses that you can't immediately deduct.  You carry the losses forward to future years until you either have a rental profit, which you can then offset dollar for dollar, or until you sell the house.  Then you can deduct any remaining losses that you have not been able to deduct.

If you make more than $150K and a buddy tells you to invest in rental real estate for the tax break, he is full of......full of something foul and smelly.  Rental real estate can be a good investment, but not for an immediate tax break.  It can be good for price appreciation potential, which can be taxed at the lower capital gains tax breaks.  Real estate can be a great part of a retirement plan, just don't put it in an IRA.  You'll lose the capital gains tax rate that way.

If you aren't planning on holding a property for five years or more, your investment will likely be a bad deal.  Yes, I know about flippers, not the amphibian kind, the stupid kind, who believe they can outguess the real estate market.  I prepare their tax returns.  Here's how they go:  small gain on the first deal, small gain on the second deal, then total loss on the third.  Losers don't brag, liars do, however.  You've been warned.

You might also ask, "Frank, how do I become a real estate professional?  That way I can deduct my losses regardless of my income."

There are two requirements to be considered a real estate professional.  First, you must have at least 750 hours in real estate activities.  That seems simple enough to meet.  However, the second requirement is that more than half of your work hours must be spent in a real estate related profession or trade.  That's the tough one.  If you have W-2 income from a non-real estate job, you probably can't qualify.

"But Frank, how will the IRS know whether I spend more than half my time in real estate?"

Here's how to find out. Try deducting a rental loss when you have substantial W-2 wage income.  You will likely get a personal invitation to your local IRS office.  You'll need a log of your hours to prove more than half your time was in real estate.  No log, no deduction.

Think broadly about the potential expenses you may be able to deduct against your rental income.  Let's start with this partial list:
a. Mortgage interest
b. Real estate taxes
c. Utilities
d.  HOA dues
e. Repairs
f. Depreciation
g.  Travel to the rental
h. Professional fees
i.  Landscaping and maintenance
j. Management fees and rental commissions
h.  Cleaning supplies

For depreciation, you depreciate the building, not the land, using the straight line method over 27.5 years.  Why 27.5 years?  Why not?  Tax law doesn't have to make sense.  How do you separate the building value from the land value?  Look at your tax appraisal.  That will give you the proportion of the total property value that is building.  You then apply that percentage to either your original cost of the property or the market value when you make the property available for rental.  You use the lower of the two values.  You do include settlement costs in the original purchase price.

You also get depreciation deductions for improvements and major replacements.  Improvements attached to the structure of the building are depreciated over 27.5 years.  Replacement appliances are depreciated over five years.  IRS publication 527 covers expenses related to residential rental real estate.  You can get it at www.irs.gov.  It's great bathroom reading, guaranteed to cure constipation.

There are three primary schedules you'll use to report your rental activity on your personal tax returns, schedule E, form 4562, and form 8582.  Schedule E is the main form where you list the rental income and expenses.  Form 4562 is the form where you calculate depreciation.  Form 8582 is where you determine how much of your rental loss is deductible and how much carries forward to future years.  You can also get these forms at www.irs.gov.  This site's porn for tax preparers.  Sad, but true.  At least it's free.

Good luck in renting out your house.  You'll need it.  The tax complications are the least of your worries.  You'll face idiot tenants.  You'll get to pay moron contractors to repair your property.  All of this is pure joy.  Trust that I know this from experience.  We just received a contract to sell our rental property.  If I had to make a choice between that sales contract and sex with Jennifer Aniston.....well it's a close call.

Thanks fro reading!  As always for real tax and accounting advice, visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw Up Your Small Business" Facebook page.  I post snarky and helpful business advice several times each day.

Until next time, let's do it to them before they do it to us.