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.
Basics of Taxation on Rental Real Estate
As with all types of business income, the investor in rental real estate activities is taxed on net income from the property. This is the rental income, 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.
Depreciation and mortgage interest expense often result in losses for rental real estate. Losses are not taxable.
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.
Understanding Passive Activity Limits: What is a Passive Activity?
A passive activity refers to a trade or business activity in which the taxpayer does not materially participate. According to the IRS, a passive activity includes any involvement where the taxpayer does not actively engage in the day-to-day operations or decision-making processes.
In terms of rental real estate, a passive activity is any rental operation where the taxpayer does not actively partake in the management or operational duties of the property, such as rent collection, overseeing maintenance and repairs, and making property-related decisions. This will be considered to be a passive activity, subject to the passive activity rules.
The passive activity loss rules are designed to prevent taxpayers from using losses from passive activities to offset income from non-passive sources, such as wages, interest, dividends, capital gains and other business income.
What is Active Participation?
On the other hand, active participation implies involvement in significant management decisions, such as approving new tenants, deciding on rental terms, and authorizing major repairs. This level of involvement can potentially allow investors to qualify for certain tax benefits, such as the small landlord exception, which permits the deduction of up to $25,000 in rental real estate losses against non-passive income if the investor’s modified adjusted gross income is below a specific threshold.
Modified Adjusted Gross Income (MAGI) and Phase-Out Limits
Modified Adjusted Gross Income (MAGI) is a critical factor in determining the phase-out limits for the $25,000 rental real estate loss deduction. MAGI is calculated by combining all amounts used to figure adjusted gross income, excluding passive income or loss, rental real estate losses and other specified items. The phase-out limits for passive activity losses are as follows:
- If MAGI is $100,000 or less, the deduction is $25,000.
- For every $2 increase in MAGI above $100,000, the deduction is reduced by $1 until MAGI reaches $150,000.
- If MAGI is above $150,000, the deduction is completely phased out.
Who is a Real Estate Professional?
For those heavily involved in real estate, achieving real estate professional status can be advantageous. This status allows taxpayers to bypass the passive activity loss limitations, enabling them to deduct losses from rental activities against other types of income. However, qualifying as a real estate professional requires meeting strict criteria, including spending a significant amount of time in real estate activities and materially participating in the rental operations.
Suspended Passive Activity Losses and Rental Property
Passive losses may offset other passive income.
However, 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. However, there is an important exception to this rule when it comes to capital gains from rental real estate. When you sell a rental property, the suspended losses that were generated over the years from the rental 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.
Real Estate Professional Tax Status
Let’s go into more detail about real estate professional status, as it is a common issue for clients of our CPA firm.
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 “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.
Qualifying as a Real Estate Professional
To qualify as a real estate professional, you must spend at least 750 hours in a real estate trade or business and more than half your total working hours must be in a real estate trade or business. Meeting these requirements will not necessarily allow you to deduct your rental losses against your ordinary income; you must also materially participate in the rental activity.
To materially participate in a rental activity, you must pass one of the material participation tests, which involve being involved in the operation of the activity on a regular, continuous, and substantial basis. This can include activities such as managing the property, handling maintenance and repairs, and making decisions about the property.
Real estate professionals can deduct their real estate expenses against their ordinary income, which can provide significant tax benefits. However, it’s essential to keep accurate records of your hours worked in the real estate trade or business, as well as your material participation in the rental activity, to qualify for these benefits.
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
A significant participation activity is a trade or business activity in which an individual participates for more than 100 hours but does not meet the criteria for material participation. This classification helps in determining the eligibility of taxpayers to utilize certain tax benefits and limitations associated with passive activities.
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.
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/investor 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.
IRS Definition of a Real Estate Professional: An Example
To qualify as a real estate professional, an individual must meet specific requirements set by the IRS. One of the key factors is the number of hours spent in real estate activities. For example, let’s say John is a full-time real estate agent who spends 1,000 hours per year working on rental properties, managing properties, and performing other real estate-related tasks. He also spends 500 hours per year on his own rental properties, which he actively manages. In this case, John would meet the IRS definition of a real estate professional, as he spends more than 750 hours per year in real estate activities and more than half of his total working hours are in real estate.
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, and deductions are limited to property taxes and mortgage interest. This rule provides a unique opportunity for homeowners to generate rental income without incurring additional tax liabilities.
As a historical note, the Augusta Rule was originally created for the citizens of Augusta, Georgia, allowing them to rent out their homes tax-free during the Masters Tournament golf championship each year. For example, a homeowner in Augusta could rent their home for $1,000 per night during the tournament and earn $14,000 tax-free if rented for 14 days.
Another example might involve a homeowner in a coastal town who rents out their home during a popular local festival. If they rent their home for $500 per night for 10 nights, they could earn $5,000 tax-free under the Augusta Rule.
These examples illustrate how homeowners can capitalize on local events or peak seasons to maximize their tax-free rental income.
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.
Bonus depreciation refers to the depreciation of certain fixed assets in the year of acquisition. For example, if an investor purchases a new HVAC system for a rental property, this asset may qualify for bonus depreciation, allowing the investor to deduct the entire cost of the HVAC system in the year it is placed in service.
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 increases 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.
Example of Cost Segregation
Consider an investor who purchases a rental property for $500,000. Through a cost segregation study, it is determined that $150,000 of the purchase price can be allocated to assets eligible for accelerated depreciation, such as appliances, landscaping, and certain interior fixtures. This allocation allows the investor to claim a larger depreciation expense in the initial years, thereby increasing the deductible rental real estate losses. Even with the phase-out of 100% bonus depreciation, this strategy enables the investor to significantly reduce taxable income from the rental activity.
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.
Example of a 1031 Exchange
Imagine you own a rental property valued at $300,000 with a $100,000 gain. If you sell the property without a 1031 exchange, you would have to pay capital gains taxes on that $100,000. However, if you use a 1031 exchange, you can defer these taxes by reinvesting the proceeds into a new property of equal or greater value. For instance, you sell your property and purchase a new rental property for $350,000. By doing this, you defer the capital gains taxes, allowing you to leverage your entire gain to grow your real estate investments further.
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.
For example, if you own a rental property and only provide basic services such as heat and light, cleaning of public areas, and trash collection, you would not be subject to self-employment tax on your rental income. These are considered customary services in connection with the rental of rooms or other spaces for occupancy.
On the other hand, the provision of substantial services in conjunction with a property rental will trigger the self-employment tax. Examples of situations that do trigger the self-employment tax are rentals in hotels, boarding houses, tourist camps, parking lots, warehouses, or storage garages. For instance, if you run a bed-and-breakfast where you offer daily maid service and meals, this would be considered providing substantial services, and therefore, the income would be subject to self-employment tax.
Example of Self-Employment Tax Calculation
Let’s say you operate a bed-and-breakfast and earn $50,000 in net income from this activity. Since you provide substantial services, this income is subject to self-employment tax. The self-employment tax rate is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare.
To calculate the self-employment tax:
- Multiply the net income by the tax rate: $50,000 x 15.3% = $7,650.
Therefore, you would owe $7,650 in self-employment taxes on your bed-and-breakfast income.
Entity Choice for Rental Property and Asset Protection
When it comes to rental properties, choosing the right entity structure is crucial not only for tax purposes but also for asset protection. The primary purpose of putting real estate into an LLC (Limited Liability Company) is to shield your personal assets from potential lawsuits related to the property. An LLC offers liability protection by treating each property as a separate entity, thus safeguarding your other assets in the event of legal action.
While an LLC does not inherently reduce taxes, it is a popular choice for rental real estate investors due to its ability to protect personal assets. Should you have a separate LLC for each rental property? This decision largely depends on your risk tolerance and the advice of your legal counsel.
Example of Asset Protection
Imagine Sarah, a real estate investor who owns several rental properties. She forms an LLC for each of her properties. One day, a tenant at one of her properties slips and falls, leading to a lawsuit. Thanks to the LLC structure, only the assets within that specific LLC are at risk, protecting Sarah’s personal assets and her other properties from being targeted in the lawsuit. This separation ensures that her personal finances and other investments remain secure, illustrating the importance of asset protection through LLCs.
S Corp Issues in Real Estate
On the other hand, the S corporation can be advantageous for real estate businesses subject to self-employment tax, such as hotels, real estate flippers, and real estate agents. However, it is generally not suitable for rental real estate investors because rental real estate activities are typically considered passive activities. Since passive income from rental properties is not subject to self-employment tax, the primary tax advantage of an S corporation—reducing self-employment taxes—does not apply. Additionally, using an S corporation for rental real estate can complicate tax reporting and limit flexibility in transferring property ownership, as transferring property into or out of an S corporation can trigger taxable events.
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 how much to pay yourself for more information on that important topic.
Example of Reasonable Compensation
Consider a real estate agent who operates through an S corporation. The agent earns $150,000 in net income from their business activities. To comply with IRS regulations, the agent must pay themselves a reasonable compensation for their services, which might be determined based on industry standards, experience, and the nature of the work performed. In this case, the agent decides to set a salary of $70,000, which is considered reasonable given their experience and the average salary for similar roles in the industry. This salary is subject to payroll taxes, while the remaining $80,000 can be distributed as dividends, potentially reducing the overall tax burden.
Example of Entity Choice for Rental Property and Asset Protection
Consider Jane, who owns three rental properties. She decides to form an LLC for each property to protect her personal assets from potential lawsuits. Each LLC is treated as a separate entity, offering liability protection. However, Jane understands that the LLCs do not provide any tax benefits.
On the other hand, her friend Mark operates a real estate business flipping houses and chooses to form an S corporation. This choice allows Mark to save on self-employment taxes due to the active nature of his business. While this structure benefits Mark, Jane realizes that an S corporation would not be advantageous for her rental properties due to their passive nature.
In conclusion, while LLCs are ideal for asset protection in rental real estate, S corporations may be more beneficial for active real estate businesses seeking tax savings. Always consult with your CPA and legal advisor to determine the best entity choice for your specific situation.
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