Note: This article is meant for general information and is not providing tax advice to the reader.
Buying rental property—either commercial or residential—can be a lucrative investment and a good way to diversify your investment portfolio. If you are considering owning rental property, here are some things to know from a tax perspective before making a purchase, while managing your rental property, and when you want to sell.
Understanding passive income. Owning a rental property with a long-term tenant is different from other businesses from a tax perspective. In many businesses, you can deduct expenses from your income, reducing the total amount that is taxable. In most cases, you would pay income tax, Social Security tax, and Medicare taxes on that business income. Money that is earned from running a business, similar to receiving a salary, is considered active income by the IRS.
A rental property, where you basically are getting “mailbox money,” is considered passive income by the IRS. This is income from activities where you have no active or direct involvement. If you made a profit from your rental property, you would have to pay income tax but you would not be subject to Social Security or Medicare taxes.
Losses from your rental property are generally not able to offset active income, such as income from a salaried position. Instead, these passive losses would carry forward each year. Then, when you have other passive income such as other rental properties or another passively held business, your rental income losses could be taken to offset that income.
Becoming an LLC. Another issue to consider before you invest in a rental property is what type of entity should be used to make that investment. Generally speaking, a real estate investment should be set up as an LLC, and not as a C-corporation or an S-corporation. Tax rules for an LLC partnership or individual ownership allow for better capital gains or loss treatments than an S-corp or C-corp.
If you are a married couple and you own a single property, you could hold that property in an LLC or in your own name. If you own the property in your own name, you will need to prepare a Schedule E to report income or loss from rental real estate. If as a married couple you own more than one property, it might be beneficial to create an LLC.
If multiple people are going to own a property, the entity should be a multi-member LLC. This kind of LLC is required to prepare an annual partnership tax return (due March 15, not April 15) and create K-1 partnership statements for each LLC member. In turn, each LLC member would include their K-1 partnership information on their respective personal tax returns.
Depreciation is different. If you already own a business, you are aware that certain assets can be depreciated over time, which lowers your tax burden. The IRS has determined a class life, or number of years over which an asset can be depreciated. For items like office furniture, it’s seven years, while a truck used for business is five years. With real estate, the value of a building and other structural components are depreciated over 27.5 years for residential or over 39 years for commercial. Other assets such as new kitchen appliances depreciate over five years. The value of the land is not depreciated at all.
Long-term liquidity. Owning rental properties should be seen as an investment similar to putting money in the stock market. The biggest difference is that real estate has the least liquidity. You cannot submit an online order to sell a piece of land and have cash in your account the next day. Often a return on investment on a real estate purchase takes years. Real estate investors should have a long-term viewpoint, knowing that the offset to liquidity is the likelihood of making more money in the long run.
Time to sell. When the time comes to sell your rental property, any increase in the value of that property will be subject to capital gains tax. However, all those years of deferred passive losses can now be taken to offset the gain and reduce your tax burden. To ensure the most benefit, you will need good bookkeeping records for each property. Whether you manage this yourself or hire a bookkeeper, consistent recordkeeping is critical to capturing and tracking income and expenses over time.
Talk with a tax advisor. As with any major financial decision, make sure to check with your tax advisor before making any real estate investment—especially if this is your first real estate purchase or sale. Talking with a tax advisor can help you determine the best way to maximize your financial benefit and minimize your tax burden. (To learn more about tax planning, see our recent blog post.)
To learn more about real estate investing and business tax advisory services by Marlene Van Sickle CPA go here. If you are interested in real estate investing and would like to discuss your project, contact us at info@vansicklecpa.com.
IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or applicable state and local provisions or (2) promoting, marketing, or recommending to another party any tax-related matters addressed herein.