Rental Property

Building Wealth with Less Tax Debt

Rental properties are important vehicles for investment and tax. They build wealth and reduce tax. People investing in real estate usually start with buying rental houses. When you buy a rental house you get to deduct all the expenses associated with the rental property.

You get to deduct the interest, the property taxes, the insurance on the house, the utility, the homeowner’s association fees, repairs and maintenance of the property and insurance. You may get to deduct travel expenses if it is applicable.

You must also report the income on the property. When you lease the property usually the renter pays the first month and a deposit. You should include the first month rent in income but the deposit is not part of your income.

There are issues associated with rental property such as the value of the house, repairs and depreciation that need some examination.

Value of Rental Property

The value of rental property is usually your cost of acquiring the property. It does not include the prorated interest and taxes or commission or other closing costs. These items are usually treated as expenses in the year you acquire the property.

So the value of the house is usually the agreed upon price. This value is your beginning point for calculating depreciation of the rental property. We say it is your beginning point because this amount needs to be adjusted. You must deduct from this amount the value of the land because land is not depreciated (if any lands usually appreciate.)

You must calculate a certain percentage for the land to be excluded form the value of the rental property. The net amount is the depreciable amount. Deprecation of rental property is usually a long term depreciation approaching thirty years give or take depending on the law prevailing at the time. We will discuss this further below.

Repairs vs. Capitalization and Deprecation

In an IRS audit the auditor loves to examine the repair expenses. Their eyes are usually on the nature of the treatment that you follow in reporting repairs. For example if you painted a room, you will typically report this as repairs. The IRS will go along with this treatment.

But say the carpet has gotten so bad that you had to change it. You reported this as repairs. Most likely the IRS will disallow this expense as repairs and insist that you should treat this item as capital item subject to depreciation. One would ask so what is the big deal since they will allow me the deduction anyway.

No one wants to teat repairs as capital items. We as taxpayers want to treat these items as immediatedeductibles. Immediately means now, means this year. Take the example of the carpet. If you spend seven hundred dollars on the carpet and you treat it as an expense, you get to deduct the whole seven hundred in the same year.

But if the IRS says you should treat it as capital item that should be deducted instead of now over the useful life say of seven years, they will allow you only one hundred dollars every year.

Needless to say that we, as taxpayers, all want to deduct the whole seven hundred now not over several years. This adverse treatment of capitalization and thus depreciation is not what we want. We want repairs now. The IRS want depreciation and later.

Depreciation Tricks

Many CPA's, attorneys, enrolled agents or other tax practitioners often fail to take advantage of a way to accelerate deduction of rental property depreciation. Remember we said that you must deduct some amount for the land from the cost of the house.

We suggest that you deduct another amount from the cost (about ten percent for equipment). Then what is left is the cost of the structure itself. We prefer to deduct equipment and depreciate it separately form the structure because the structure is depreciated over a long time say twenty seven years while the machinery and equipment in the house such the AC and dishwasher etc, can be depreciated faster, say seven years.

This will accelerate your annual deduction and gives you a bigger bang for rental property deductions.

Section 179 and Rental Property

Remember that you cannot deduct the equipment that you buy for rental property as section 179. Section 179 allows you instead of deducting the equipment over several years or the life of the assets to deduct it immediately. This treatment is reserved to business property and it is a tremendous investment incentive.

Suspended Losses

There is a twenty five thousand dollars maximum deduction the rental house every year. The question is do we lose any amount of expenses beyond the twenty five thousand dollars? The answer is no. We call these suspended losses.

We can carry those losses in future years. They remain with you from year to year. If you could not deduct them and you sell your rental house, you can benefit from those deductions that were suspended in time. They adjust your basis and hence reduce your gain.

That is why we advise that if you change your CPA, tax attorney or your enrolled agent, take your prior tax return to the new preparer. That way they can see these tax carry forwards and other tax attributes.