Well 5 of them, I’m only going to count on one hand. I probably hear some variation of this every month: I thought having rental property would save me on taxes.
Well, it does. It just may not always be obvious. We’ll go through some ways that having rental property can “save” you on taxes. Not everyone will see the same results because their tax situations vary.
For our purposes we are going to assume we are talking about a residential rental property that is reported on a Schedule E. This discussion assumes the typical independent landlord situation. Some situations may have “ifs” and “buts” not discussed here.
- Tax Savings through depreciation.
Depreciation is the reduction of value of an asset over time due mainly to wear and tear. For this point we’ll focus on what is usually the biggest depreciable asset for a landlord, the house or building. If you buy a rental property or convert a primary residence into rental property you don’t get to deduct the basis or value of the property in one year. You have to spread it out over many years. It may sound like a bad deal, but it tends to work out great especially since most often much of the cost of a rental property was paid by borrowing. If you earned $20,000 of rent and If you can deduct $10,000 a year through depreciation (money you didn’t spend that year), then you only get taxed on $10,000 of rent. Instant tax savings. There will be other expenses of course that lower your taxable income even lower, maybe even to the point of a loss which we will discuss later.
Depreciation is actually a more complicated subject than many make it out to be, including me in this little snippet. You can read more about depreciation and the errors associated with it here.
I know, I know. You are thinking “depreciation is awesome, it must be too good to be true”. Well it is awesome, but there is a catch. That is called depreciation recapture. The short version of depreciation recapture is that the IRS wants you to pay back the benefit of taking that depreciation when you sell the property. You can read more about depreciation recapture here.
- Rental Income is not subject to payroll or self employment taxes.
For most landlords operating residential rental property is considered a passive activity. In this article we are discussing those landlords, of which I am one. Passive doesn’t mean it is effortless to make money as a landlord, but instead passive refers to how the income is treated from a tax perspective. Rental income is also referred to as unearned income (although as a landlord I can tell you I am certain I have earned it). Passive income and unearned income is not subject to payroll taxes. If you compare that to W-2 income, you save 6.345% from payroll taxes which include social security and medicare taxes. If you compare the rental income to self employment income, you save 15.3% (social security and medicare taxes when self employed). Although when you are self-employed you do get a deduction on your 1040 for half of the self-employment taxes you saved, so the savings calculation is a little more complicated and the savings is slightly less.
But the point is that rental income is not taxed as heavily as some other income. But what if you don’t have a profit, so no income? That is where passive losses come into play.
- Passive Losses
It is common for landlords to have years in which on paper (due to depreciation recapture) or in reality (due to heavy expenses) to have a loss. The good news is if you have a loss you don’t pay taxes on a loss. But a loss can provide tax savings in other ways as well.
a) The general rule is that a passive loss can only reduce passive income. So if one rental property has $10,000 of profit and another rental property has a $10,000 loss then the net income is zero. Instant tax savings. But what if your rental activity is a net $10,000 loss and your only other income is “active”, like W-2 income? Then that loss is saved up and carried over to the following year, providing no tax benefit to the year of the loss.
b) There are special situations in which a passive loss can “count” against earned income. One is the $25,000 special allowance. When your total Income (modified adjusted gross income, MAGI) is less than $100,000 ($50,000 for filing Married Filing Separate) then you can apply those losses against other income like W-2 income up to $25,000. This is called a special allowance and permitted if you have active participation in the operation of the rental. So if your MAGI is $80,000 the passive loss can lower the AGI to $70,000 so you won’t get taxed on $10,000 of your W-2 income. From $100,000 to $150,000 ($50,000 to $75,000 filing Married Filing Separate) this special allowance phases out, down to zero.
c) If you have losses in excess of your special allowance or if you don’t have a special allowance those losses carry over like mentioned above. There is still tax savings, but it is delayed. If the following year or any later year there is passive income, those losses can offset that income. The losses can also be applied in full if you sell the rental property.
- Deferring capital gains taxes and in some cases avoiding capital gains taxes
As your rental property gains in value, you have a capital gain that you don’t have to pay taxes on until you sell the property. That is referred to as deferring taxes, putting them off to a later date.
Some capital gains taxes can be avoided entirely (except for depreciation recapture) up to a limit of either $250,000 or $500,000 if you meet what is known as the 5 year rule or one the exceptions to the 5 year rule. Often military service members can make use of an exception for qualified official extended duty. You can read more about avoiding capital gains taxes on the sale of a home here.
There can be other ways to defer capital gains and depreciation recapture and even avoid them all together. Those ways don’t work for everyone and won’t be discussed here.
- Qualified Business Income (QBI) Deduction
The QBI deduction was brought to us by the The Tax Cuts and Jobs Act (TCJA) that went into effect in 2018. Under current law this provision expires at the end of 2025. For qualifying income, 20% of that income is deducted so that it isn’t subject to taxation.
I know, I know what you are thinking. Residential rental property isn’t a business so how can a landlord qualify for QBI? There are two ways. The first is to meet a safe harbor provision provided by IRS regulations. This requires meeting 250 hours of certain activity and tracking those hours. Extra work. The second method is simply to ensure that your residential rental activity rises to the level of trade or business. “Rising” to the level of trade or business isn’t really all that difficult and I expect that most residential rental properties are at that level. The first bar is you have to have a profit motive. And the short version of the rest of what rises to the level of trade or business is simply to operate like you really have a profit motive. You can read more about QBI here.
There you have it. Five ways owning residential rental property saves you on taxes. These are the concepts. Placing them correctly into action can take some due diligence on your part. It may be wise to engage a tax professional to make sure of the “correctly” part.