BOULDER – As the housing market continues to boom in many parts of the country, it may be tempting to consider renting properties to earn some extra cash. Before you do, however, it’s imperative that current and prospective landlords understand the tax ramifications. Here’s what you need to know.
Owning and renting properties has some attractive tax benefits. Landlords can write off mortgage interest and real estate taxes, standard operating expenses associated with owning a rental property (such as utilities, insurance, and repairs), and an annual depreciation deduction, to name a few.
However, during the first few years of property ownership, it is extremely common for landlords to spend more on a rental property than they take in. This is known as a rental loss.
In some instances, losing money can also have tax benefits. You are generally able to deduct those losses from your other income earned through activities like investments or a job. The catch is that this rule does not apply to rental losses, also known as passive activity losses (PALs).
Income earned from owning rental properties is considered “passive income”, which is income generated from an activity that you don’t “materially participate” in. You would have passive income if you earn a profit from one or more rental properties, in tax terms.
Unfortunately for many landlords, passive losses can only be deducted from passive income. Therefore, you could not deduct these passive activity losses from your taxes unless you have enough passive income to offset the loss, sell the property, or meet the criteria of one of the exceptions below:
You’re a real estate professional
To qualify, you must spend more than 750 hours of the year on real estate activities in which you “materially participate” (read the IRS criteria for that here). Additionally, the hours you spend on real estate activities must be greater than 50% of all the time you spend working on personal service activities. If you meet these criteria, you may deduct the passive losses incurred from the rental properties in which you materially participate.
You are an active investor
You may deduct up to $25,000 of rental property losses if (1) your modified adjusted gross income is less than $100,000 and (2) you actively participate in the property.
The word “active” is critical in this instance. Active participation means owning a 10% or greater stake in the property and making management decisions, such as approving tenants, signing leases, and authorizing repairs. It’s very important to note that if you hire a management company to handle everything, you are not considered an active participant and will be ineligible for this exception.
Your rental property is in a resort area
As vacationers come and go, the typical rental period for a property in a resort area is seven days or less. The IRS considers this more akin to a transient lodging operation than a rental property operation, so you’re declared ineligible for both of the exceptions above. However, if you materially participate in renting out the property, you can generally deduct your passive losses in the year they are incurred. To see the full passive loss rules, review IRS Publication 527 (Residential Rental Property) at www.irs.gov.
In many instances, renting properties can produce a generous secondary income and tax benefits, but be sure to educate yourself before making the leap.
Michaela Phillips is the Vice President of Mortgage Lending at Guaranteed Rate, Inc., the 8th largest retail mortgage company in the country. Since entering the mortgage industry in 1994, she’s consistently been a top producer. Being a VP at Guaranteed Rate offers many advantages to her and her clients including unparalleled customer service, efficiency, and most importantly competitive rates. Contact Michaela at 303.579.5517 or via e-mail at firstname.lastname@example.org. NMLS:312874. michaelaphillips.com
By Michaela Phillips, Guaranteed Rate, Inc.