Owning a rental property is a great investment but can also create some tricky tax scenarios. Here are some top tax tips for rental property owners or those considering purchasing rental property as an investment.
Rental Property Tax Considerations
When filling out your tax returns, your rental property income and expenses are documented in Schedule E. Income includes the rental payments you received. Expenses include your mortgage, repairs and maintenance, utilities, management fees and all other costs associated with the property.
If you payed points on the loan used to purchase your rental property, you cannot deduct them completely from your taxable income like you can on a property purchased as a primary residence. You must deduct the points over the whole length of your loan.
Your taxable income from the rental property results when yearly rental income exceeds expenses.
If your property’s expenses are larger than the Schedule E rental income, then you can deduct losses from your taxable income if your non-property based income (i.e. your job) is less than $150,000 in the tax year. Here’s the breakdown:
- If less than $100,000 in non-property income, you can deduct up to $25,000 of any losses your rental property incurred
- If between $100,000 and $150,000, you can deduct up to $12,500
- If your non-property income is above $150,000, then you may not deduct any rental property losses
The last bullet is not such good news. However, if your earnings are above the threshold to deduct any rental property losses, you should keep track of the losses over the course of your ownership … any cumulative loss that is not deductible can be used to offset the capital gains taxes when you sell the property.
You should seek additional guidance from your tax adviser to see whether you can deduct rental losses from your taxable income or whether you can accrue losses to offset future capital gains taxes.
Tax Considerations When Selling Your Rental Property
When you sell a rental property, the Federal Government will kindly ask that you pay capital gains taxes on your appreciation. It’s advisable that you seek out a tax adviser to give you an accurate breakdown of deductible costs and the taxable capital gains. You can can get a rough idea of your net profit and estimate of your capital gains taxes as follows:
- Take your property sale price and deduct the purchase price, the cost of any modifications to improve the property, and all selling costs (including local taxes, agent fees, etc.).
- The figure you are left with is your capital gain on the property,
- Based on your non-property income, you may have to pay up to 30% in federal and state taxes on your capital gains.
Ok, here’s a quick example to see how the numbers work out…
If you bought a rental property 8 years ago for $200,000 and put 20 percent down with a standard 6% fixed rate 30 year mortgage, your current balance would be $140,435. If you made $10,000 in improvements to the property over the 8 years and sold it for $300,000, with no losses to offset you would be left with capital gains of around $69,000, after paying local taxes, agent fees, etc. Of the capital gains accrued you would have to pay somewhere between $17,000 and $21,000 in taxes, leaving around $120,000 from the sale of the property.
How To Minimize Rental Property Capital Gains Taxes
If you intend to buy a new rental property immediately after selling you can defer paying any capital gains taxes. The 1031 Exchange IRS benefit enables you to defer paying any capital gains taxes if you can identify, in writing, a new rental property within 45 days and complete the purchase of the property within 180 days of selling your previous rental property. To defer paying any capital gains taxes your new rental property should be at least equal to the value of your sold property and you must invest all of the proceeds from your rental property sale. The 1031 Exchange defers and does not eliminate the taxes on the sale of your rental property. However, the IRS does not prohibit turning your new rental property into a primary residence in the future. Before taking part in a 1031 Exchange you should consult a tax advisor to ensure eligibility and how it may affect your unique tax situation.
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