Steadily rising rents over recent years (some of which have bounced by nearly 15% in some areas of the country)—are bad news for tenants. But they can be a prime opportunity to make passive income as a landlord. Though tax laws pertaining to rental income are robust enough to justify the 24 page IRS Publication 527, understanding some of their basic but fundamental principles can help all potential landlords gauge whether the profits they intend to make sync with the tax laws to which they’ll be subject.
Here are a few tax-related questions to consider before you decide to rent out your property for income.
Will you ever live in the property? The IRS is clear that in most cases, all income generated by a rental property must be reported on your tax return. Yet timing is an essential component to the tax implications that income may present. If you live in a property and rent it out for less than 15 days out of the year, for example, you are not technically a rental property owner, according to the IRS. That means you do not report the money you make from such transactions as rental income—and cannot deduct related expenses. If you live in the property some of the time but rent it out occasionally (like with a vacation home), you must divide the expenses you can deduct to reflect your personal use of the property compared to the rental use; how much you can deduct may be limited in tandem. If you pay points on a mortgage loan when you purchase the property but never live in it, how much and when you can deduct those points is limited, too.
How will you collect income? Assuming you use the “cash method” to report income on your tax return, you’ll report rental income that you receive for the year, in the tax year you receive it—even if it wasn’t in the form of actual cash. Rental income under tax law includes monthly rent, money a tenant may pay you for cancelling a lease, expenses your tenant pays for the maintenance or upkeep of your property (though some may be qualifying deductible rental expenses). Services your tenant may provide in exchange for reduced rent, like house painting, landscaping, or plumbing services are also considered income, and should be reported based on fair market value.
What expenses will work to your benefit? The ability to depreciate the cost of rental property can be a significant tax benefit—particularly if the property increases in value over the years. Expenses like mortgage interest, insurance premiums paid in full for the tax year, advertising, professional fees, maintenance, taxes and utilities related to the property can be deducted, too. If you strategize your rental income with these expenses each year, renting your property essentially allows you to form a situation where a tenant pays you to own a property that continually increases in value, and provides annual tax advantages.
How long will you want to be a landlord? Having a sense of how long you can ride out the highs and lows of renting property will impact how much taxes you potentially owe as a result. Generally speaking, you will pay long-term capital gains taxes on a property you own for at least a year if you sell it for more than it you paid. (The profit you report will be calculated using the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions). Because the property’s appreciation isn’t taxed until you sell, a tax advisor can also help you explore ways to legally benefit from the appreciation well before the sale, including taking a second mortgage on the property to capture some of the appreciation, tax free. If you’re committed to being a landlord for several years, you could also avoid capital gains entirely by rolling the proceeds of your rental property sale into a similar type of investment through a Section 1031 Exchange. Though 1031 rules are complex, they essentially allow landlords to swap one rental property for another “like property” (even if it’s a much better property), with minimal tax implications.
