Military Officers Tend to End Up With Rentals
Over a career, it is likely that a military officer will end up with a rental or two. This is due to the fact that we move a lot and sometimes those moves happen with little to no warning. It can also be part of a financial strategy and be quite effective. But, if you're going to be a landlord, you need to be aware of how the Tax Code governs rental properties.
Tax Impacts of Owning Rental Real Estate
First of all, you need to declare the rent you receive on your individual tax return. Failure to do that can put you in a really bad place...like jail (assuming a conviction on tax evasion). But, that doesn't mean you'll have taxable income. There are several things that can reduce the amount of taxable income the property produces.
- On-Going Expenses. At the very basic level, if you spend a dollar on your rental to make a dollar it is deductible. Things like repairs, maintenance and cleaning, management fees, mortgage interest, insurance, property taxes and homeowners association dues are all deductible in the year incurred. These expenses decrease your income dollar for dollar.
- Depreciation. All the expenses above basically are recognized in a single year. For instance, having the house cleaned is a single event. Some costs are not consumed in the same year they are "purchased". The actual house you're renting is one such thing. You paid money to purchase the house and now produce income. But unlike an expense you can't claim that expenditure in one year. You must take the deduction over time. This is called depreciation and it accounts for the fact that things wear out over time and the expense should be deducted over time. In the case of rental residential real estate, the lifespan is 27.5 years. So, you will deduct a little under 4% of the value of the structure (not the land) rented each year for 27.5 years. What is the value? The value for calculating depreciation (not the same as for calculating gain or loss) is the lesser of the purchase price of the structure plus improvements or the Fair Market Value of the structure when the property is placed on the market. One other thing...and this is really important. Depreciation is NOT really optional. While you can file your return without claiming the deduction, you'll be using an unauthorized accounting system and when you sell the property you must pay taxes on any depreciation recapture (described below), regardless of whether you actually depreciated the property or not.
- Losses. If the expenses plus depreciation for the year exceed the rent received, you have a loss. Rental property is normally considered a passive activity and passive losses can only be used to offset passive gains. There is a special provision for rental real estate that allows taxpayers who actively participate in the management of the property to deduct up to $25,000 in losses against ordinary income. The IRS specifies what active participation includes. In general, things like setting rent and approving repairs move you towards active participation. The amount you can deduct phases out from $100,000 to $150,000 of Adjusted Gross Income (AGI). At $100,000 of AGI you get the full deduction of $25,000 but at $150,000 you don't get any. So, if you're an O-6 or above or have a spouse that has earned income you may already be in or over the phase-out range. Any loss that you can't deduct carries forward to a year when you either have passive gains or sell the property.
Tax Impacts when Selling Rental Real Estate
When you sell the property, the IRS will be very interested in the transaction. Here is what they'll want to know about the property...and potentially tax it.
- Capital Gains. If you sell the property for more than the original purchase price plus improvements, these gains will be treated like other capital gains. If you've owned the house for more than one year, then the tax rate for most of the readers of this blog will be 15%. For those who have already retired and on a second career, there could be an additional ObamaCare Surtax of 3.8% if your AGI is greater than $250,000 if Married Filing Jointly or $200,000 for all others.
- Depreciation Recapture. Depreciation recapture (more correctly called 1250 gains) results from a bit of weirdness in the tax code. As mentioned above, you reduce the value of your property based on it "wearing out" and becoming less valuable. In the case of real estate, when you actually sell the property it is likely that it didn't go down in value and in fact went up in value. That's why you bought the property, right? Well when that happens the IRS says, "Wait a minute. You said it was less valuable than when you bought it and now you're selling it for more. You lied!" Well...they might not actually say that, but the amount over the depreciated value up to the original purchase price (plus improvements) is a taxable gain. These gains are based on the depreciation allowed or allowable (see above, depreciation is NOT optional) are called 1250 gains or depreciation recapture and are subject to a maximum tax of 25%. The ObamaCare surtaxes above apply as well and could increase the overall rate to 28.8%.
An Avoidance Technique and a Special Military Tax Benefit
If you don't want to pay the tax now and are willing to continue being a landlord, there is a special technique to defer paying the taxes on the sale. And you may be able to avoid the capital gains taxes if you lived in the property prior to the sale.
- 1031 Exchange. If you want to stay in the rental business and are willing to buy a new rental property or properties under specific rules you can defer the capital gains taxes and depreciation recapture until some point in the future. You must purchase the replacement property under a strict timeline and you can't get any money out from the transaction. Finally, the exchange must be made through a Qualified Intermediary. Come back to this blog in the future for more information on 1031 exchanges.
- Primary Residence Exclusion. If you've lived in the house for 2 of the last 5 years, you can claim the house as your primary residence and avoid the tax on the capital gains, but not the depreciation recapture. If you moved pursuant to PCS orders, then the criteria for the exclusion could stretch to 2 of the last 15 years. Read more about this special military tax benefit here.
A Reasonable Investment Choice for Military Officers
Real estate is one of the last great tax shelters. Even if you can't deduct losses, you can, assuming a positive cash flow, shelter income from taxation. That can be a great benefit. With that said, ownership of rental real estate is not for everyone. If you do go down the path of owning rental real estate, either by choice or are forced to by a PCS, make sure you fully understand the tax ramifications or get help from someone who does.