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Archives for September 2020

Renting Residential Real Estate — A Tax Review for the Nonprofessional Landlord

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Investing in residential rental properties raises various tax issues that can be somewhat confusing, especially if you are not a real estate professional. Some of the more important issues rental property investors will want to be aware of are discussed below.

Rental Losses

Currently, the owner of a residential rental property may depreciate the building over a 27½-year period. For example, a property acquired for $200,000 could generate a depreciation deduction of as much as $7,273 per year. Additional depreciation deductions may be available for furnishings provided with the rental property. When large depreciation deductions are added to other rental expenses, it’s not uncommon for a rental activity to generate a tax loss. The question then becomes whether that loss is deductible.

$25,000 Loss Limitation

The tax law generally treats real estate rental losses as “passive” and therefore available only for offsetting any passive income an individual taxpayer may have. However, a limited exception is available where an individual holds at least a 10% ownership interest in the property and “actively participates” in the rental activity. In this situation, up to $25,000 of passive rental losses may be used to offset nonpassive income, such as wages from a job. (The $25,000 loss allowance phases out with modified adjusted gross income between $100,000 and $150,000.) Passive activity losses that are not currently deductible are carried forward to future tax years.

What constitutes active participation? The IRS describes it as “participating in making management decisions or arranging for others to provide services (such as repairs) in a significant and bona fide sense.” Examples of such management decisions provided by the IRS include approving tenants and deciding on rental terms.

Selling the Property

A gain realized on the sale of residential rental property held for investment is generally taxed as a capital gain. If the gain is long term, it is taxed at a favorable capital gains rate. However, the IRS requires that any allowable depreciation be “recaptured” and taxed at a 25% maximum rate rather than the 15% (or 20%) long-term capital gains rate that generally applies.

Exclusion of Gain

The tax law has a generous exclusion for gain from the sale of a principal residence. Generally, taxpayers may exclude up to $250,000 ($500,000 for certain joint filers) of their gain, provided they have owned and used the property as a principal residence for two out of the five years preceding the sale.

After the exclusion was enacted, some landlords moved into their properties and established the properties as their principal residences to make use of the home sale exclusion. However, Congress subsequently changed the rules for sales completed after 2008. Under the current rules, gain will be taxable to the extent the property was not used as the taxpayer’s principal residence after 2008.

This rule can be a trap for the unwary. For example, a couple might buy a vacation home and rent the property out to help finance the purchase. Later, upon retirement, the couple may turn the vacation home into their principal residence. If the home is subsequently sold, all or part of any gain on the sale could be taxable under the above-described rule.

Home Office Tax Tips

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Working from home can potentially deliver some attractive tax advantages. If you qualify for the home office deduction, you can deduct all direct expenses and part of your indirect expenses involved in working from home. Note, however, that qualifying for such deductions became harder under the Tax Cuts and Jobs Act of 2017 (TCJA). If you previously claimed a home office as a miscellaneous deduction on your individual income tax return, the TCJA eliminated that deduction for tax years 2018-2025. You must now file a Schedule C on Form 1040 to be eligible for the home office deduction.

What Space Can Qualify?

Direct expenses are costs that apply only to your home office. The cost of painting your home office is an example of a direct expense. Indirect expenses are costs that benefit your entire home, such as rent, deductible mortgage interest, real estate taxes, and homeowner’s insurance. You can deduct only the business portion of your indirect expenses.

Your home office could be a room in your home, a portion of a room in your home, or a separate building next to your home that you use to conduct business activities. To qualify for the deduction, that part of your home must be one of the following:

Your principal place of business. This requires you to show that you use part of your home exclusively and regularly as the principal place of business for your trade or business.

A place where you meet clients, customers, or patients. Your home office may qualify if you use it exclusively and regularly to meet with clients, customers, or patients in the normal course of your trade or business.

A separate, unattached structure used in connection with your trade or business. A shed or unattached garage might qualify for the home office deduction if it is a place that you use regularly and exclusively in connection with your trade or business.

A place where you store inventory or product samples. You must use the space on a regular basis (but not necessarily exclusively) for the storage of inventory or product samples used in your trade or business of selling products at retail or wholesale.

Note: If you set aside a room in your home as your home office and you also use the room as a guest bedroom or den, then you won’t meet the “exclusive use” test.

Simplified Option

If you prefer not to keep track of your expenses, there’s a simplified method that allows qualifying taxpayers to deduct $5 for each square foot of office space, up to a maximum of 300 square feet.

Contact us today to discover how we can help you keep your business on the right track. Don’t wait, give us a call today.

Defer Tax with a Like-Kind Exchange (aka 1031 Exchange)

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1031People who sell real estate at a gain often want to use the proceeds to purchase additional real estate.  However, people have to pay tax on the gain before they can use the proceeds to buy more real estate.  Often, they are surprised that they have to pay tax on the gain when they’re rolling the proceeds into more real estate.

Taxpayers in this situation can avoid paying tax immediately on the sale by entering into a like-kind exchange.  In a like-kind exchange, taxpayers exchange their property with another taxpayer’s property without cash exchanging hands.  If taxpayers can’t find another party to exchange properties with, multi-party exchanges (described in my next blog) can be structured.

Like-kind exchanges can include business for business, business for investment, investment for business, or investment for investment property.  Inventory, partnership interests, and stocks and bonds do not qualify for like-kind exchange treatment.  The term like-kind refers to the nature and character of the property and not to its grade or quality.  Real estate can be exchanged only for other real estate, and personal property can only be exchanged for other personal property.

A major benefit of like-kind exchanges is that the taxpayer can acquire new property on a pre-tax basis.

Example:  Suzy has property with a $100,000 cost and a $250,000 market value.  If she sells the property she will pay tax of 15% on her $150,000 gain, which amounts to $22,500.  After paying tax, Suzy only has $227,500 of the proceeds left to purchase new property.  If Suzy can enter into a like-kind exchange, she can defer paying tax and will be able to acquire new property worth the $250,000 value of her old property.

With a like-kind exchange, tax is deferred rather than avoided.  When a taxpayer exchanges a property, the original cost of the old property is applied to the new property.

Example:  Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000..  Andy owns Parcel 2, which he bought for $120,000 but is now worth $250,000.  They exchange properties.  Barney now owns Parcel 2, with a cost of $100,000 and a market value of $250,000.  Andy now owns Parcel 1 with a cost of $120,000 and a market value of $250,000.  Neither pays tax at the time of the exchange.  However, tax is not permanently avoided because Barney will have a taxable gain of $150,000 when he later sells Parcel 2 and Andy will have a taxable gain of $130,000 when he later sells Parcel 1.

To fully defer tax, no cash or assets other than the exchanged properties can change hands.  If cash (including relief from debt) changes hands, taxable gain may be recognized to the extent of cash and other assets received.  Cash and other assets received in a like-kind exchange are referred to as “boot”.

Example:   Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000.  Andy owns Parcel 2, which he bought for $120,000 but is now worth $230,000.  They exchange properties and Andy pays Barney $20,000 because his property is worthless than Barney’s.  Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 cash he received.  Andy’s exchange is still completely tax deferred because he received no boot.

Example 2:  Barney owns Parcel 1 which he bought for $100,000 but is worth $250,000. Assume Barney has a $20,000 mortgage on Parcel 1.  Andy owns Parcel 2, which he bought for $120,000 but is worth $230,000.  They exchange properties and Andy assumes Barney’s $20,000 mortgage.  Since Barney was relieved of the $20,000 mortgage, he has received boot.   Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 mortgage relief he received.  Andy’s exchange is still completely tax deferred because he received no boot.

The basis of the new property is equal to the basis of the old property:

  • Plus boot paid
  • Less boot received
  • Plus gain recognized

For both of the above 2 examples, Barney’s basis in Parcel 2 is:

Basis of Parcel 1:              $100,000

Plus boot paid:                  $0

Less boot received:          ($20,000)

Plus gain recognized:          $20,000

Basis of Parcel 2:               $100,000

If Barney immediately sells Parcel 2 for $230,000, he will recognize a gain of $130,000 ($230,000 sales price less basis of $100,000).  When you add this $130,000 gain on sale to the $20,000 gain Barney recognized when he received the $20,000 boot, you have $150,000 which is the economic gain Barney had in Parcel 1.  Notice how the economic gain of $150,000 is taxed as Barney received cash of $20,000 during the like-kind exchange, and $130,000 when he sells Parcel 2 for cash.

For both of the above 2 examples, Andy’s basis in Parcel 1 is:

Basis of Parcel 2:               $120,000

Plus boot paid:                  $20,000

Less boot received:                   $0

Plus gain recognized:                 $0

Basis of Parcel 1:               $140,000

If Andy immediately sells Parcel 1 for $250,000, he will recognize a gain of $110,000 ($250,000 sales price less basis of $140,000).  This is the economic gain he had in Parcel 2.

 

Selling Inherited Property? Tax Rules That Make a Difference

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Sooner or later, you may decide to sell property you inherited from a parent or other loved one. Whether the property is an investment, an antique, land, or something else, the sale may result in a taxable gain or loss. But how that gain or loss is calculated may surprise you.

Your Basis

When you sell property you purchased, you generally figure gain or loss by comparing the amount you receive in the sale transaction with your cost basis (as adjusted for certain items, such as depreciation). Inherited property is treated differently. Instead of cost, your basis in inherited property is generally its fair market value on the date of death (or an alternate valuation date elected by the estate’s executor, generally six months after the date of death).

These basis rules can greatly simplify matters, since old cost information can be difficult, if not impossible, to track down. Perhaps even more important, the ability to substitute a “stepped up” basis for the property’s cost can save you federal income taxes. Why? Because any increase in the property’s value that occurred before the date of death won’t be subject to capital gains tax.

For example: Assume your Uncle Harold left you stock he bought in 1986 for $5,000. At the time of his death, the shares were worth $45,000, and you recently sold them for $48,000. Your basis for purposes of calculating your capital gain is stepped up to $45,000. Because of the step-up, your capital gain on the sale is just $3,000 ($48,000 sale proceeds less $45,000 basis). The $40,000 increase in the value of the shares during your Uncle Harold’s lifetime is not subject to capital gains tax.

What happens if a property’s value on the date of death is less than its original purchase price? Instead of a step-up in basis, the basis must be lowered to the date-of-death value.

Holding Period

Capital gains resulting from the disposition of inherited property automatically qualify for long-term capital gain treatment, regardless of how long you or the decedent owned the property. This presents a potential income tax advantage, since long-term capital gain is taxed at a lower rate than short-term capital gain.

Be cautious if you inherited property from someone who died in 2010 since, depending on the situation, different tax basis rules might apply.