IRS Rules for Rental Property: What You Need to Know
The IRS rules for rental property provide many tax advantages for the investor. In this article, we will talk about the tax basics that every investor in rental real estate should know.
IRS Rules for Net Losses from Rental Property
Like other 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.
Therefore, even 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 provided that it is operating at a net loss for tax purposes.
Passive Real Estate Losses
Investments in real estate are subject to the passive activity loss rules. Here is a short summary of how the passive activity loss rules work.
Rental real estate is presumed to be a passive activity. Income from rental real estate is called passive income. Losses from rental real estate are called passive losses.
The passive activity loss rules apply both to rental properties owned directly as well as rental properties owned with others in a partnership.
Passive losses from rental real estate are allowed to be offset against passive income. Passive losses may not be offset against non-passive income. Non-passive income includes wages, interest, dividends, capital gains and other business income.
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.
Suspended losses are carried forward into the future, until other passive income is generated. The suspended passive loss will reduce the passive income generated in that future year.
If passive income is never generated, then the suspended passive loss will become available to offset all income (including non-passive income) when the taxpayer sells the activity. This includes any capital gains on the sale of the real estate that originally generated the losses.
$25,000 Tax Exception
If Adjusted Gross Income (AGI) of the investor is $100,000 or less for the year, he or she may deduct up to $25,000 of passive losses against non-passive income (such as wages, interest, dividends, capital gains and active business income).
If AGI is over $100,000, this deduction is phased out. The deduction is completely eliminated when the investor’s AGI reaches $150,000.
Real Estate Professional Tax Loophole: Step 1
If AGI is over $150,000, the real estate professional exception is the only way to offset passive losses against other income. This rule allows taxpayers who meet the definition of a real estate professional to offset passive losses against other types of income without limit. An election is required to be filed with the tax return in order to implement this rule.
In order the qualify as a real estate professional, the investor must:
- 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
Because of these rules, it is generally very difficult for investors to qualify as real estate professionals if they are also working a full time job outside of real estate.
Investors who do meet these rules should keep a log of real estate hours per year in case of an IRS audit. This is important.
For married couples, if one spouse qualifies as a real estate professional, than both spouses will qualify.
Materially Participating Real Estate Professional: Step 2
To qualify for the real estate professional exception, investors must also be able to demonstrate material participation in the rental property. This is in addition to the tests discussed above in Step 1.
Real estate investors must pass one of seven tests in order to demonstrate material participation The most common of these tests are:
- working 500 hours per year on the rental property,
- working 100 hours per year and more than anyone else on the rental property, OR
- 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 real estate makes it easier to pass one of these tests. In contrast, using a property manager makes this more difficult.
These tests are done separately on a property by property basis. However, investors may make a grouping election on their tax return, which makes these tests much easier to meet.
Example: A full-time realtor/investor will probably qualify as a real estate professional, 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. The realtor/investor must pass the tests in both Step 1 and Step 2 for the passive loss exception for real estate professionals to apply.
Not all activities are considered when calculating the number of real estate hours per year. 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.
Short-Term Rental Loophole
Short-term rentals are not considered passive rental activities. This means that the passive activity loss rule do not apply if the rental are short-term. Therefore, losses from a short-term rental property (like an Airbnb) may be offset against all other income with limitation.
To qualify as long as a short-term rental, the investor must meet one of two tests:
- the average period of customer use is 7 days or less, OR
- the average period of customer use is 30 days or less if cleaning, meals or other substantial services are provided to the customer
The short-term rental exception does not require that the investor meet the tests in Step 1 for a real estate professional.
However, and this is important: the investor must still be able to demonstrate material participation (Step 2) for the short-term rental exception to apply.
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 compose 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
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.
Click here to read more about this topic in our article on Cost Segregation.
1031 Exchange
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.
Read more about 1031 exchanges in our article on Section 1031 Exchange and the Delaware Statutory Trust.
LLC for Rental Property
The purpose of putting real estate into an LLC is to protect your other assets in the event of a lawsuit.
Should you have a separate LLC for each rental property? It depends on your risk tolerance. Check with your lawyer.
The LLC does not save taxes.
However, the entity structure that does save taxes (specifically self-employment taxes, also called social security taxes) is the S corporation. This strategy works for most businesses, including real estate flippers, service businesses, eCommerce and retail. However, it does not apply to rental estate investors, because self-employment taxes do apply to rental real estate.
Rental Activity and Self-Employment Tax
The IRS generally excludes net rental income from the 12.4% tax on self-employment income.
The exclusion from self-employment tax generally applies to rentals from living quarters when no services are rendered for the occupants.
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.
Examples of situations which do trigger the self-employment tax are rentals in hotels, boarding houses, tourist camps or tourist homes, parking lots, warehouses, or storage garages.
In 2021, the IRS ruled in Chief Counsel Advice 202151005 that the following are substantial services which trigger the self-employment tax:
- Renting a vacation property with linens, kitchen utensils, all items making the property fully habitable, daily maid services, delivery of individual-use toiletries and other sundries, Wi-Fi service, beach access, recreational equipment, and prepaid ride-share vouches between the property and the nearest business district.
In the same ruling, the IRS stated that the following are not substantial services and therefore do not trigger the self-employment tax:
- Renting a fully furnished room and bathroom without access to most common household areas such as the kitchen or laundry room. Cleaning was only provided between each occupant’s stay, and the example included no discussion of any other items furnished to the occupants.
Check with your CPA or tax adviser to assess the significance and materiality of all services provided to residential tenants to determine whether or not the 12.4% self-employment tax will apply.
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