In any economy, real estate owners are always focused on their internal rate of return. However, in periods of economic decline, savvy real estate owners seek out opportunities to improve their bottom line. A tax break called “cost segregation” can produce significant tax savings that can be realized immediately.
Most taxpayers who own residential rental property depreciate the entire cost of their building over 27.5 years. Those who own other types of buildings, such as offices, retail space, grocery stores, restaurants, warehouses, and manufacturing plants often depreciate the entire cost using a 39-year or 31.5-year depreciation period, depending upon the date of acquisition. However, according to the IRS cost segregation guidelines, a substantial portion of a building’s cost can be depreciated over much shorter periods, usually five or seven years!
A cost segregation study acceptable under IRS standards is an extensive review that analyzes a property’s construction to isolate its structural components. The cost segregation rules are complex, but in short, they enable a real estate owner to depreciate those components of a building that are unrelated to its “operation and maintenance” over a shorter depreciation period. Moreover, these depreciation deductions are calculated using an accelerated depreciation method, which allows costs to be recovered at twice the rate applicable to the real estate property itself (typically 27.5 to 39 years).
The shorter depreciation period and accelerated depreciation method can apply to many types of building components. It is impossible to list them all, but some common examples include molding, millwork, and other decorative elements, carpeting, wall coverings, partitions, window treatments, counters, cabinets, shelving, special lighting, specialized machinery and equipment (such as kitchen equipment), and the costs of plumbing and electrical allocable to such equipment. In addition, certain land improvements located outside the building can be depreciated over 15 years. These land improvements can include landscaping, fences, sidewalks, curbs, parking lots, lighting, utilities, signs, swimming pools, tennis courts, and playgrounds.
Cost segregation studies are applicable to properties that are newly built, rehabilitated or acquired. Depending on the type of building, you can expect to deduct between 10 and 60 percent of its cost over the shortened recovery periods.
Is Rental Income Taxable?
Yes, rental income is taxable, but that doesn't mean everything you collect from your tenants is taxable.
You're allowed to reduce your rental income by subtracting expenses that you incur to get your property ready to rent and then to maintain it as a rental. You report rental income and expenses on Schedule E, Supplemental Income and Loss.
When Do I Owe Taxes on Rental Income?
In general, you must report all income on the return for the year you actually receive it even though it may be credited to your tenant for a different year.
· If you receive rent for January 2007 in December 2006, for example, report the rent as income on your 2006 tax return.
· If you receive a deposit for first and last month's rent, it's taxed as rental income in the year it's received.
· If you receive goods or services from your tenant in exchange for rent, you must value the goods or services at their present worth and report that value on your return for the year that they are received.
You must also report income that you have received constructively. This means the funds are available to you even if you haven't taken possession of them. For example, if your renters place their January checks in your mailbox late in December, you cannot avoid reporting the rent as income simply by not removing the checks from the mailbox until January.
Are Security Deposits Taxable?
Security deposits are not included in income when you receive them if you plan to return them to your tenants at the end of the lease. (Deposits for the last month's rent are taxable when you receive them, because they are really rents, paid in advance.)
What If I Pocket Some of the Security Deposit?
If you eventually keep part or all of the security deposit because the tenant does not live up to the terms of the lease, you must include that amount in the income on your tax return for the tax year in which the lease terminates. Of course if you withhold the security deposit to cover damages caused by the tenant, the cost of repairing such damage will be deductible, and offset the rental income.
So you should keep track of the security deposits from year to year. This record-keeping isn't difficult if you only own one rental, but as the number of rentals you own increases, so does the paperwork.
If I Rent Out My Vacation Home, Can I Still Use It Myself?
Only for a very limited amount of time each year, if you want the chance to deduct losses on your rental property. To be treated as a business for tax-loss purposes, your use of the property can't exceed 14 days or 10% of the days the unit is rented during the year, whichever is greater. Ten percent may sound like a lot, but really isn't when you figure that a seasonal rental may only be in demand for two or three months each year. For example:
Costs you incur to place the property in service, manage it and maintain it generally are deductible. Even if your rental property is temporarily vacant, the expenses are still deductible while the property is vacant and held out for rent.
Deductible expenses include, but are not limited to, the following:
· Advertising
· Cleaning and maintenance
· Commissions
· Depreciation
· Homeowner's associations dues and condo fees
· Insurance premiums
· Interest expense
· Local property taxes
· Management fees
·
· Professional fees
· Rental of equipment
· Rents you paid to others
· Repairs
· Supplies
· Trash removal fees
· Travel expenses
· Utilities
· Yard maintenance
All expenses you deduct must be ordinary and necessary, and not extravagant.
You can deduct the cost of travel to your rental property if the primary purpose of the trip is business. If you mix business with pleasure, though, you're required to allocate the travel costs between deductible business expenses and non-deductible personal costs. Be careful not to cheat yourself on the break down.
Consider this example: John, who lives in
But following that advice would be a costly mistake. Since the primary purpose of the trip is business, the full cost of transportation to and from
Now, if John spent three days skiing and two days working on the condo, none of his travel expenses would be deductible, although the direct costs of working in the apartment (the cost of paint and cleaning supplies, etc.) would be deductible rental expenses.
Keep good records. To deduct any expense, you must be able to document the write-off. So hold on to all receipts, checks, and bank statements.
Can I Deduct Improvements and Repairs?
Ah, there's a big difference between improvements and repairs. The cost of improvements to the property must be depreciated over their useful lives (which are defined by the IRS), rather than deducted in the year paid. The cost of repairs can be written off in the year you pay them.
Improvements are actions that materially add to the value of the property or substantially prolong its life. Examples include:
· Additions to the structure
· Adding a swimming pool
· Installing a water filtration system
· Modernizing a kitchen
· Installing insulation
Repairs, on the other hand, just keep the property in good operating condition. Examples of repairs:
· Minor repainting
· Repairing appliances
· Fixing leaks
· Replacing broken windows or doors
For more information see IRS Topic 414: Rental Income and Expenses.
How do I Calculate Depreciation?
Depreciation is a deduction taken over several years. You generally depreciate the cost of business property that has a useful life of more than a year, but gradually wears out, or loses its value due to wear and tear, weather damage, etc. To figure out the depreciation on your rental property:
1. Determine your cost or other tax basis for the property.
2. Allocate that cost to the different types of property included in your rental (such as land, buildings, so on).
3. Calculate depreciation for each property type based on the methods, rates, and “useful lives” specified by the IRS.
1. Determine Your Cost Basis
Your cost basis in the property is generally the amount that you paid for the property (your acquisition cost plus any expenses), including any money you borrowed to buy the place.
If you are converting your property from personal use to rental use, your tax basis in the property is calculated differently. Your basis is the lower of these two:
· Acquisition cost
· The fair market value at the time of conversion from personal to rental use
If the property was given to you or if you inherited it, or if you traded another property for the current property, there are special rules for determining your tax basis in your rental property. If you were given the property, for example, your basis is generally the same as the basis of the generous soul who gave it to you; if you inherited it, your basis is generally the property's value on the day the previous owner died. Consult IRS Publication 551, Basis of Assets, for more information about these situations.
2. Allocate the Cost by Type of Property
After determining the cost or other tax basis for the rental property as a whole, you must allocate the basis amount among the various types of property you're renting. When we speak of types of property, we refer to certain components of your rental, such as the land, the building itself, any furniture or appliances you provide with the rental, etc.
If your rental is a condo or other property that shares property within a community, you're deemed to own a portion of that property. A portion of the land and a portion of the purchase price must be allocated to the land upon which the building is built.
Why this effort to divide your tax basis between property types? They are each depreciated using different rules and different lives.
3. Calculate the Depreciation for Each Type of Property
Here are the most common divisions of tax basis for a rental property, followed by explanations of the different methods of depreciation.
Type of Property | Method of Depreciation | Useful Life in Years |
Land | Not depreciated | N/A |
Residential rental real estate (buildings or structures and structural components) | Straight line | 27.5 |
Nonresidential rental real estate | Straight line | 39 |
Shrubbery, fences, etc. | 150% declining balance | 15 |
Furniture or appliances | Double (200%) declining balance | 5 |
Straight-Line DepreciationIn straight-line depreciation, the cost basis is spread evenly over the tax life of the property.
Example:
A residential rental building with a cost basis of $150,000 would generate depreciation of $5,455 per year ($150,000 / 27.5 years).
In the year that the rental is first placed in service (rented), your deduction is prorated based on the number of months that the property is rented or held out for rent, with 1/2 month for the first month. If the building in the the example above is placed in service in August, you can take a deduction for 4-1/2 months of $2,046 ($5,455 x 4.5 / 12).
Declining Balance DepreciationThis kind of depreciation is calculated by multiplying the rate, 150% or 200%, by the straight-line depreciation calculated based on the adjusted balance of the property at the start of the year over the remaining life of the property. To make matters somewhat easier, the IRS and others publish tables of percentages that can be applied to the original cost to determine yearly depreciation. Here's the five-year property table as an example:
Year
Percentage
1
20.00
2
32.00
3
19.20
4
11.52
5
11.52
6
5.76
Total
100%
Example:
Declining balance depreciation on $2,400 worth of furniture used in a rental would be $461 in Year 3 ($2,400 x 19.20%).
Tables for all types of properties can be found in IRS Publication 946: How to Depreciate Property. For general information on depreciation of rentals, see IRS Publication 527: Residential Property.
How do I Report a Rental Activity on My Tax Return?
As an individual, you report the income and deductions for rental properties on Schedule E, Supplemental Income and Loss. The total income or loss computed on Schedule E carries to Form 1040.
Report the depreciation of rentals on Form 4562: Depreciation and Amortization. The instructions for these forms explain in detail how to complete these forms.
TurboTax products assist you with compiling rental data and reporting the information on the appropriate lines of the appropriate forms.
What Are Passive Activities and How Do They Affect Me?
Rental properties are, by definition, passive activities and are subject to passive activity loss rules. These rules are quite complex. In general, the passive activity rules limit your ability to offset other types of income with net passive losses.
But the good new is there is an exception: If you actively participate in a rental activity you can deduct up to $25,000 of the rental loss. To actively participate means that you own at least 10% of the property and you make major management decisions, such as approving new tenants, setting rental terms, approving improvements, and so forth. (No, you don't have to mow the lawn or answer middle-of-the-night phone calls from tenants about a backed-up toilet.
But this exception phases out as your income rises. If you have modified adjusted gross income over $100,000, the loss you can deduct decreases by $0.50 for every dollar over $100,000. The maximum loss is completely phased out when your modified adjusted gross income reaches $150,000. (Modified adjusted gross income is determined by calculating adjusted gross income without regard to deductions for IRA contributions or pensions, taxable social security benefits, adoption assistance payments, income excluded from U.S. savings bonds used to pay higher education tuition and fees, interest on qualified student loans, the tuition fees deduction, and any passive activity loss of taxpayers in a real property business.)
Example:
Phil and Mary have modified adjusted gross income of $90,000 and a rental loss for the year of $21,000. They actively participated in the rental. Since their modified adjusted gross income is below the limit of $100,000, their entire rental loss is deductible. If their loss had risen to $28,000, they would have been limited to a deductible loss of $25,000 this year - the balance of $3,000 would be "carried over" to future years' returns until completely used up.
If you're married and you file a separate tax return from your spouse, and if you lived apart from your spouse at all times during the year, the maximum rental loss deduction under the exception is $12,500. Your loss begins to phase out at $50,000 instead of $100,000.
If you're married and file separately but you did not live apart from your spouse at all times during the year, the active rental real estate loss allowance is not available to you.
You may need to complete Form 8582: Passive Activity Loss Limitations, following the published IRS instructions.
If you work in real estate, you may be considered a real estate professional. The passive activity rules don't apply to real estate activities for many properties owned and managed by real estate professionals. For more information regarding this important exception, consult IRS Publication 527: Residential Rental Property.
For more on passive activities, see Tax Topic 425: Passive Activities-Losses and Credits.
This kind of depreciation is calculated by multiplying the rate, 150% or 200%, by the straight-line depreciation calculated based on the adjusted balance of the property at the start of the year over the remaining life of the property. To make matters somewhat easier, the IRS and others publish tables of percentages that can be applied to the original cost to determine yearly depreciation. Here's the five-year property table as an example:
Year | Percentage |
1 | 20.00 |
2 | 32.00 |
3 | 19.20 |
4 | 11.52 |
5 | 11.52 |
6 | 5.76 |
Total | 100% |
Example:
Declining balance depreciation on $2,400 worth of furniture used in a rental would be $461 in Year 3 ($2,400 x 19.20%).
Tables for all types of properties can be found in IRS Publication 946: How to Depreciate Property. For general information on depreciation of rentals, see IRS Publication 527: Residential Property.
How do I Report a Rental Activity on My Tax Return?
As an individual, you report the income and deductions for rental properties on Schedule E, Supplemental Income and Loss. The total income or loss computed on Schedule E carries to Form 1040.
Report the depreciation of rentals on Form 4562: Depreciation and Amortization. The instructions for these forms explain in detail how to complete these forms.
TurboTax products assist you with compiling rental data and reporting the information on the appropriate lines of the appropriate forms.
What Are Passive Activities and How Do They Affect Me?
Rental properties are, by definition, passive activities and are subject to passive activity loss rules. These rules are quite complex. In general, the passive activity rules limit your ability to offset other types of income with net passive losses.
But the good new is there is an exception: If you actively participate in a rental activity you can deduct up to $25,000 of the rental loss. To actively participate means that you own at least 10% of the property and you make major management decisions, such as approving new tenants, setting rental terms, approving improvements, and so forth. (No, you don't have to mow the lawn or answer middle-of-the-night phone calls from tenants about a backed-up toilet.
But this exception phases out as your income rises. If you have modified adjusted gross income over $100,000, the loss you can deduct decreases by $0.50 for every dollar over $100,000. The maximum loss is completely phased out when your modified adjusted gross income reaches $150,000. (Modified adjusted gross income is determined by calculating adjusted gross income without regard to deductions for IRA contributions or pensions, taxable social security benefits, adoption assistance payments, income excluded from U.S. savings bonds used to pay higher education tuition and fees, interest on qualified student loans, the tuition fees deduction, and any passive activity loss of taxpayers in a real property business.)
Example:
Phil and Mary have modified adjusted gross income of $90,000 and a rental loss for the year of $21,000. They actively participated in the rental. Since their modified adjusted gross income is below the limit of $100,000, their entire rental loss is deductible. If their loss had risen to $28,000, they would have been limited to a deductible loss of $25,000 this year - the balance of $3,000 would be "carried over" to future years' returns until completely used up.
If you're married and you file a separate tax return from your spouse, and if you lived apart from your spouse at all times during the year, the maximum rental loss deduction under the exception is $12,500. Your loss begins to phase out at $50,000 instead of $100,000.
If you're married and file separately but you did not live apart from your spouse at all times during the year, the active rental real estate loss allowance is not available to you.
You may need to complete Form 8582: Passive Activity Loss Limitations, following the published IRS instructions.
If you work in real estate, you may be considered a real estate professional. The passive activity rules don't apply to real estate activities for many properties owned and managed by real estate professionals. For more information regarding this important exception, consult IRS Publication 527: Residential Rental Property.
For more on passive activities, see Tax Topic 425: Passive Activities-Losses and Credits.
