RENTAL REAL ESTATE TAX TIPS & RULES
The Internal Revenue Code contains specific tax rules for rental real estate that you need to be aware of when filing your federal income tax return.
How and Where To Report Ownership & Ownership Percentage
The owner of a rental real estate property (form of ownership) can be an individual, single member limited liability company disregarded entity, partnership, or S corporation. Note that other types of entities may also own rental real estate and will not be addressed on this page.
Each owner needs to determine their form of ownership and their ownership percentage.
Individuals and single member limited liabilty company disregarded entities report their rental income and rental expenses on Schedule E, Form 1040.
Partnerships and S corporations report their rental income and rental expenses on Form 8825 of their respective federal income tax returns; Form 1065 for partnerships and Form 1120S for S corporations.
Each owner reports their ownership percentage of total rental income and total of each rental expense if there are multiple owners.
Rental real estate must be depreciated over a specifice number of years per IRS depreciation tables. There are different IRS depreciation tables for residential and for commercial rental real estate.
Depreciation begins when the rental property is "Placed In Service" which means the date the rental property is ready and available for rental. This may or may not be the same date as the date the property is purchased.
In situations where a property is purchased and there are additional capital expenditures incurred before the property is ready and available for rental, these costs are added to the initial purchase price and depreciated as a part of the initial total cost of the property.
Generally the initail depreciable basis is the gross purchase price plus the closing or settlement costs incurred on the purchase, plus capital expenditures incurred to get the property ready and available for rental (if any).
For a personal residence converted to a rental property, the depreciation basis is the lower of (A) the property's adjusted basis or (B) Fair Market Value on the date of conversion to rental use.
Depreciation contuinues until either the property is no longer a rental, is fully depreciated, or until it is sold or otherwise disposed of.
Rental Real Estate Losses: $25,000 Special Allowance Deduction
Rental real estate activities are passive activities to owners and subject to the passive activity loss rules (unless the owner meets the various criteria to be deemed a "real estate professional"). Generally, passive activity losses can onlt be deducted against passive activity income. The $25,000 Special Allowance makes an exception whereby rental real estate losses (passive activity losses) may be eligible to be deducted against other income (earned and portfolio/investment income).
Thus, there is a $25,000 Special Allowance For Rental Real Estate Losses which allows otherwise non-deductible passive activity losse from rental real estate activities to become deductible (against earned and portfolio/investment income) if certain criterial are met as follows:
1-The owner must "actively participate" in the rental activity.
2-The $25,000 maximum deduction starts to phase out when the owners modified adjusted gross income is between $100,000 -$150,000.
3-The special allowance is not allowed if you are married, file a separate tax return, and lived with your spouse at any time during the year.
4-If you are married, filing a separate tax return, and did not live with your spouse at any time during the tax year, your maximum deduction is $12,500 and is phased out if your modified adjusted gross income is between $50,000-$75,000.
5-Rental real estate losses that are not allowed are suspended and carried forward to subsequent years where they may be deducted if the taxpayer is eligible for a deduction or when the property is sold to an unrelated party in a fully taxable transaction.
Sale of Rental Property: Gain or Loss
Accumulated Depreciation MUST deducted each year from the property's depreciation basis to arrive at adjusted basis. The adjusted basis is then deducted from the amount realized (gross selling price less closing/settlement costs) to arrive at the gain or loss on sale. The gain or loss calculation is a follows:
Gross Sale Price
Less: Closing/Settlement Costs to sell
= Amount Realized from sale
Less: Adjusted Basis (depreciation basis less accumulated depreciation)
= Gain or Loss on sale.
The gain is taxable income and the loss is deductible.
Unpleasant Tax Surprise When A Gain Results
It is important to plan ahead if there is a taxable gain because taxpayers are often "unpleasantly" surprised to learn that they owe taxes and could also be subject to various IRS penalties since no taxes are withheld on the taxable gain. Quarterly estimated tax payments should be considered when the rental is sold at a gain.
Remember: accumulated depreciation reduces the property's adjusted basis and the lower the adjusted basis the higher the potential taxable gain and taxes due.
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