Many first time landlords may not realize that renting out a home means more than just collecting monthly rents. In fact, it has tax implications based on rental property depreciation that can be beneficial depending on your circumstances. For that reason, I strongly recommend speaking with a tax professional.
If you're considering becoming a landlord, you'll be interested in what Michael Roth, CPA and principal at Offit & Roth P.A., Certified Public Accountants, has to say. In this article, he offers rental property depreciation advice that puts into perspective some of the tax deductions available to those considering renting out a personal property.
Michael Roth, CPA, Offers Depreciation Advice for 1st Time LandlordsLinda: Michael, what is your background and your role with Offit & Roth P.A., CPA?
I am a principal of Offit & Roth and a certified public accountant. I've been practicing for 15 years.
The firm was started 65 years ago by my maternal grandfather, Sylvan Offit; 40+ years ago, my dad decided to join him. I'm the 3rd generation in the family business. (See the history of the Offit & Roth firm.) We provide client-focused, exceptional accounting services and unparalleled tax solutions.
We focus on 400 entity clients which range from startups to companies with $150m in sales, and provide a broad array of tax, business and estate planning services. 90% of our clients are within the Baltimore, Washington, and Virginia area, yet we file income tax returns in almost every state of the union.
Linda: Michael, what is the definition of a rental property?
Rental property is real estate or property placed in service for the business of collecting rents in exchange for using the property or living on it. There are specific rules on how many days can be used for personal use while still being classified as a rental per the IRS.
Linda: Given your expertise in accounting and taxes, could you help us understand what kinds of tax deductions or rental property depreciation exist for 1st time landlords?
In my opinion, when people decide to purchase rental property, or to rent out an existing property for the first time, they are looking for cash flow and evaluating if renting out is better than the expenses associated with the property. Many fear having to pay taxes on the rental income.
What many - and particularly first time landlords - don't realize is that rental property depreciation offsets the rental income, creating an additional expense.
For residential rentals, depreciation applies to the structure; you divide the value of the structure by 27.5 years and that's the yearly depreciation expense you have available.
So, for example, if you have a residential rental property that you paid $350K for and $75K represents the value of the land, you would divide the remaining $275K value by 27.5 and apply that $10K to your tax return as a tax deduction. If offsets the cash flow you receive from tenants.Linda: How do first time landlords make use of tax deductions from rental property depreciation?
Rental property owners must include several additional forms when they file their yearly 1040 tax form:
- Schedule E For Supplemental Income and Loss for rental activity (i.e., rental income and expenses associated with the rental)
- Form 4562 For Depreciation and Amortization which details depreciation amortization. This is where you show the property value and the associated depreciation expensed each year on Schedule E. This form is an attachment to Schedule E.
There is a caveat to be aware of. Every year that you depreciate the rental property, the basis for the value of the structure diminishes by that amount. The landlord's cost basis is lower which means that, if the property is sold, the landlord will need to pay a capital gain tax based on the adjusted cost basis if the sale price is greater. If the adjusted basis is greater than the selling the price, the owner recognizes a capital loss which can be used to offset other capital gains or deduct up to $3,000 per year and carryover the remaining balance of the loss.
Many times, rentals generate ordinary losses (expenses exceed rental income), landlords can deduct up to $25K of the loss if they make less than $100K in modified adjusted gross income. If they make over $150, they can’t deduct anything. In between, they can deduct a portion. Any loss not captured due to income restraints is carried forward to future years.
Linda: How do expenses affect tax deductions for 1st time landlords?
Unlike homeowners who can only deduct mortgage interest and real estate taxes, landlords have more expenses to deduct.
Landlords can deduct insurance expense, security system costs, home owner association fees, mileage to/from the property as a rental owner, mortgage interest and real estate taxes, as well as advertising costs, cleaning/maintenance of the property, legal and accounting expenses, management fees, repairs, and utilities. Given the expenses, it's often difficult to show a tax profit on rental property. However, it may be a cash flow benefit.
What this also highlights is that real estate might be a good alternative investment which diversifies a portfolio.
Linda: What watchouts might 1st time landlords face?
For a first time landlord, this is all new information. The biggest problem I have noticed is not fully understanding depreciation, repairs and capital improvements.
- A repair happens when something breaks, and the landlord needs to get it fixed. This is considered ordinary and routine. Maintenance falls into that category, as does minor plumbing and fixing small parts on a broken washer/dryer. These are expenses.
- Capital expenditures or capital improvements generally need to be depreciated. They improve the property, extend its useful life and generally make it better. For example, an addition or a new deck improves the property; it needs to be capitalized and depreciated.
Too many people try to expense things that should be depreciated. I see the difference as a matter of what it was before vs. what it is now. Is it the same? It's an expense. Is it better? It's a capital expenditure and needs to be depreciated.
Linda: Any other words of advice for landlords?
Each individual situation is different. For that reason, I strongly recommend working with a tax professional so first time landlords don’t go wrong with depreciation. It's important to not take advantage of the IRS while making sure to get every deduction a landlord is entitled to. Get set up correctly, keep up with the depreciation schedules and keep track of the adjusted basis of the property, and new landlords will be in good shape to benefit from their investment.Linda: Michael, how can readers contact you?
Linda: Michael, thanks very much for taking the time to educate us about tax deductions and depreciation for 1st time landlords.
You may find this article worth exploring: Renting Out Your Home: What You Need To Know.
If you're considering renting out your home, what questions do you have?
Disclaimer: Please do not rely upon this article as authoritative, please seek opinion of your tax advisor. Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.