The tax rules for rental real estate investors offer many tax advantages. Due in large part to the tax advantages, investing in real estate is very popular among people looking for an alternative source of income or side gig. Our Atlanta-based CPA firm probably sees more tax returns with real estate issues than just about any other type of business activity.
Because of its tax favored status, rental real estate remains one of the most attractive ways to accumulate wealth with the assistance of the government.
This article provides a summary of the tax rules for rental real estate, along with actionable tips to save money on taxes.
Deducting Passive Activity Losses and the IRS Tax Rules for Rental Real Estate
As with all types of business income, the investor in rental real estate is taxed on net income from the property. This refers to rental income from the property, less operating expenses to own and manage the property. Then, we subtract depreciation. This calculation often results in a net loss from the rental property, also called a rental loss.
Typically, depreciation and mortgage interest expense are the key drivers of tax losses in rental real estate. This is very common.
It does not matter if the rental property generates a positive cash flow for the investor. The IRS will not tax the investor on cash flow generated by the rental property if it is operating at a net loss for tax purposes.
Passive Activity Loss Limitations and the IRS Tax Rules for Rental Real Estate
Investments in real estate are subject to the passive activity loss rules. These rules have been with us since 1986. Here is a short summary of how the passive activity loss rules work.
The IRS characterizes rental real estate as a “passive activity.” Income from rental real estate is called passive income. Rental losses from real estate are called passive losses.
Passive Income Loss Limit
Passive losses from rental real estate may only be used to offset passive income from other rental real estate activities.
Passive losses may not be used to offset non-passive income, such as wages, interest, dividends, capital gains and other business income. For this reason, the benefit of rental losses is limited.
These restrictions are known as the “passive activity loss rules.” They apply both to rental properties owned directly as well as rental properties owned with others in an entity like an LLC or partnership.
Suspended Passive Activity Losses and Rental Property
If there is no passive income to offset against a passive loss in a given year, the passive loss is suspended. Suspended passive losses are reported on IRS Form 8582. This form is a useful tool to keep track of suspended losses. If you ever switch CPA firms, be sure to give Form 8582 to your new accountant.
Rental Loss Carry Forward
Suspended losses are carried forward into the future, until other passive income is generated. The suspended passive loss will reduce passive income generated in that future year.
Can Passive Losses Offset Capital Gains?
As mentioned above, the general rule is that passive losses may only offset passive income. Therefore, as a general rule, passive losses may not be used to offset capital gains.
However, there is an important exception to this rule when it comes to capital gains. According to this exception, when you sell a rental property, the suspended losses that were generated over the years from the property may be used to reduce or offset the capital gain from the sale of the property.
This exception only works when the real estate is sold to an unrelated third party. In addition, this exception requires a sale that is a taxable event. Therefore, a Section 1031 exchange will not qualify.
Small Landlord Exception for Rental Losses: Rental Real Estate Loss Allowance
Real estate investors may deduct up to $25,000 of passive losses against non-passive income if their Modified Adjusted Gross Income (MAGI) is $100,000 or less for the year. This is the “small landlord exception,” also called the “rental real estate loss allowance.” This allows lower income real estate investors the opportunity to reduce their wages from employment for tax purposes by up to $25,000, if their property is generating tax losses.
The small landlord exception requires active participation in the management of the rental property. Approval of new tenants and making decisions on big expenses is evidence of active participation. Also, the investor must own 10% or more of the property to be able to utilize the small landlord exception.
$25,000 Rental Loss Deduction Phase Out
If MAGI exceeds $100,000, then $25,000 allowance is reduced (phased out). The allowance is completely eliminated when the investor’s MAGI reaches $150,000. This limit applies to both single filers and married couples filing jointly.
Real Estate Professional Tax Status
The real estate professional exception is another way to offset passive losses against other non-passive income. This rule allows taxpayers who qualify as a real estate professional to offset passive losses against other types of income without limit. The status of of “real estate professional” refers to people who treat real estate as their career.
This exception from the passive activity loss rules is sometimes called the real estate professional tax loophole.
Unlike the small landlord exception discussed above, the real estate professional exception is not based on income.
Qualification as a real estate professional requires a written election to be attached to the tax return.
How To Qualify for Real Estate Professional Status (Step 1)
In order the qualify for real estate professional status (REPS), the investor must meet the following two tests:
- work at least 750 hours per year in real estate, AND
- work more than half of their total work hours per year in real estate
Typically, it is difficult for individuals to meet these requirements if they also have a full time job outside of real estate.
For married couples, if one spouse qualifies as a real estate professional, than both spouses will qualify. This is a great solution when one spouse has another career or job outside of real estate. For example, if a non-working spouse agrees to manage the properties, then they both spouses qualify for real estate professional tax benefits on their joint tax return. In other words, the IRS limitations on rental losses will not apply to them.
CPA Tax Tip: Investors who do qualify for real estate professional status should keep a log of their real estate hours per year. This is important in case of an IRS audit.(To learn additional tips about audit defense, check out our IRS Audit Guide.)
Further Requirements for the Real Estate Professional Tax Loophole (Step 2)
In addition to the qualifications for real estate professional status listed above, investors must also be able to demonstrate material participation in the rental property.
Real estate investors must pass one of seven tests in order to demonstrate material participation The most common of these tests are:
- work 500 hours per year on the rental property
- work 100 hours per year and more than anyone else on the rental property
- the investor’s participation is substantially all the participation in the rental property. This means that the investor does the majority of the work relating to the rental property
Self-managing a property makes it easier to pass these tests to qualify as a real estate professional.
Not all activities are considered when calculating the number of real estate hours per year for material participation. Qualifying real estate activities must be day to day activities related to the rental property, such as buying supplies, managing tenants, writing leases or evicting tenants. Activities that do not qualify include research, education, reviewing financials, supervising the property manager, paying bills, bookkeeping or travel to and from the rental properties.
These tests are done on a property by property basis. However, investors may make a grouping election on their tax return, which makes these qualifications easier to meet. Thus, it is important to include the real estate grouping election on your tax return when there are multiple properties, in order to qualify as a real estate professional.
IRS Definition of a Real Estate Professional: An Example
A full-time realtor/investor will probably qualify for real estate professional status (REPS), by virtue of working in a real estate business (Step 1).
However, the realtor will only meet the tests in Step 2 if he or she is actively working on a rental property for the required number of hours per year.
Short Term Rental Loophole for Rental Property
Short term rentals are not considered passive rental activities. Therefore, losses from a short-term rental property (like an AirBnB or Vrbo) may be used to offset all other income, without worrying about the passive loss limitation rules. This can be a huge benefit for the real estate investor that also has a W-2 job.
The short term rental loophole is a tax strategy that is particularly helpful for real estate investors who do not qualify for either the small landlord exception or the real estate professional status (REPS) exception, discussed above.
How to Qualify for the Short Term Rental Property Tax Strategy
To qualify for the short term rental loophole, the real estate investor must meet one of these tests:
- the average period of guest use is 7 days or less
- the average period of guest use is 30 days or less if cleaning, meals or other substantial services are provided to the guest
The short-term rental loophole does not require that the investor meet the tests in Step 1 (see above) for a real estate professional.
However, and this is important: the investor must still be able to demonstrate material participation in Step 2 (see above) for the short-term rental exception to apply.
AirBnB or Vrbo Tax Loophole: An Example
In this example, a real estate investor rents a home as an Airbnb or VRBO.
- Average period of guest use is less than 7 days or less
- The investor personally handles all activities related to the short-term rental business
The activity in this example will qualify as non-passive. If the activity generates tax losses (which is common once depreciation is calculated), then the real estate investor may use these losses to offset W-2 wages and other income. This will significantly reduce the amount of tax due on April 15.
The investor in this example will enjoy the tax savings of the short term rental loophole, even if he or she did not meet the real estate professional test of Step 1 (above).
In short, the short term rental strategy is typically easier to accomplish than the real estate professional strategy, provided that the guests do not stay long term.
CPA Real Estate Tip: The benefit of the short term rental loophole can be even greater if the investor asks his CPA to perform a cost segregation study. Cost segregation is discussed below
Augusta Rule: A Powerful Exception to the IRS Tax Rules for Rental Property
The Augusta Rule allows individuals to rent their home tax-free for up to 14 days per year. Taxes are not paid on the income. Deductions are limited to property taxes and mortgage interest.
As a historical note, the Augusta Rule was originally created for the citizens of Augusta, Georgia. The rule allowed them to rent out their homes tax free for the Masters Tournament golf championship each year.
Augusta Rule for the Business Owner
In addition to renting out your home to tourists or sports enthusiasts, the Augusta Rule also allows business owners to rent their home to their business for up to 14 days per year, tax free.
Homes include primary residence, vacation homes, apartments, condos or boats.
For example, you may rent your personal home to your business for a company retreat or business meeting. The rental price should be at a fair market rate to rent a home in that area. The owner will not pay tax on the income. And the business will receive a tax deduction for the rent paid to the owner.
This strategy only works for an S corporation, C corporation, partnership or LLC taxed as one of these three entity types.
Bonus Depreciation Phaseout
As mentioned above, losses on real estate are often generated by depreciation. Depreciation is one of the tax attributes that makes real estate so attractive to investors. It shelters cash flow from tax.
100% bonus depreciation is in effect for 2022. This means that a portion of the assets that comprise the rental property, other than the building itself and the land it sits on, can be deducted as depreciation in the year of acquisition.
However, 100% bonus depreciation is now subject to phase out, starting in 2023. Bonus depreciation will be reduced as follows:
- 80% in 2023
- 60% in 2024
- 40% in 2025
- 20% in 2026
- 0% in 2027
This means that the large losses generated by 100% bonus depreciation will get smaller over time until they are completely phased out in 2027.
Investors who purchase property before December 31, 2022 will have a greater likelihood of larger tax losses, due to 100% bonus depreciation. The passive activity loss rules will continue to apply to these losses, along with the various exceptions discussed above.
Cost Segregation and IRS Rules for Rental Property
A cost segregation study is used to allocate a greater portion of the cost of acquiring a rental property, including improvements, to assets subject to either bonus depreciation or accelerated depreciation. This greatly increased the loss that a real estate investor may deduct, subject to the passive activity loss rules and exceptions discussed above.
Even as bonus depreciation starts to phase out, cost segregation will remain financially beneficial for many years. Even without full bonus depreciation, accelerated depreciation will still apply to assets other than the building and land. Thus, cost segregation will still be beneficial. It just won’t be as dramatic as under the 100% bonus depreciation rules.
Cost segregation is particularly beneficial for short-term properties, like Airbnb, where the passive activity loss limitation rules do not apply.
Click here to read more about this topic in our article on Cost Segregation.
1031 Exchange to Defer Tax on Rental Real Estate
Section 1031 allows an investor to sell rental real estate for a gain and then roll the proceeds into another “like-kind” asset. This type of transaction is called a “1031 exchange,” which allows the investor to defer paying capital gains tax on the property which was sold.
Tax deferral means that the taxes are not due now. Rather, the taxes are on hold until a later date, perhaps years in the future. The deferred taxes on the sale of the property will eventually become due one day when the replacement like-kind property is sold without another 1031 exchange.
Nevertheless, the deferral of capital gains means less taxes to pay now and more money to invest for the future. This is a great way to speed the growth of a real estate portfolio.
A 1031 exchange requires the use of a Qualified Intermediary, who typically works with your CPA.
Read more about 1031 exchanges in our article on Section 1031 Exchange and the Delaware Statutory Trust.
Self-Employment Tax Rules for Rental Real Estate
The self-employment tax consists of Social Security and Medicare taxes for individuals who work for themselves. The self-employment tax rate is 15.3%.
Rental real estate, where services are not provided, is not subject to self-employment tax.
Services that are are customarily rendered in connection with the rental of rooms or other space for occupancy do not trigger the self-employment tax. Examples of such services are the furnishing of heat and light, cleaning of public areas, and the collection of trash.
On the other hand, the provision of substantial services in conjunction with a property rental will trigger the self-employment tax. Examples of situations which do trigger the self-employment tax are rentals in hotels, boarding houses, tourist camps, parking lots, warehouses, or storage garages.
Entity Choice for Rental Property
The purpose of putting real estate into an LLC is to protect your other assets in the event of a lawsuit. An LLC does not reduce taxes.
Should you have a separate LLC for each rental property? It depends on your risk tolerance. Check with your lawyer.
While an LLC does not reduce taxes, the S corporation does. More specifically, the S corporation can be used to minimize taxes for real estate businesses that are subject to self-employment tax. This includes hotels, real estate flippers and real estate agents.
Be sure to ask your CPA about the application of the reasonable compensation rules to S corporations. This may impact your tax planning. See our article on reasonable compensation for more information on that important topic.
The S corporation strategy is generally not useful for rental estate investors, because self-employment taxes do not apply to rental real estate where services are not provided.
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