Many people are under the mistaken belief that the end of the year brings the holidays. In reality this time of the year is tax-planning season. Due to stock market volatility and low mortgage interest rates a large number of people are building an inventory of rental properties or converting their existing homes to rental use when they purchase a new home.
Usually income received from a rental property is reported on Schedule E of Form 1040. The income reported is matched against operating expense. The large expenses are mortgage interest, property taxes, and insurance. If a loss is reported for operating the property for business purposes, it is considered a passive loss and is subjected to certain limitations and rules. In general for unmarried or married taxpayers filing a joint return, up to $25,000 ($12,500 for married filing separate returns who have lived apart the entire year) of passive losses may be used to offset nonpassive income. In order to qualify for this passive loss, the taxpayer must “actively participate” in the rental activity during the tax year the loss is incurred, have at least 10% ownership at all times, and cannot be a limited partner in the activity. Losses not allowed in the current year are carried over to future years and may be deducted when the property is sold. Some deductible expenses are:
§ Advertising
§ Auto travel
§ Cleaning and maintenance
§ Commissions
§ Depreciation
§ Homeowner’s association dues
§ Insurance
§ Landscaping and gardening
§ Legal and professional fees
§ Licenses and permits
§ Management fees
§ Mortgage interest and other interest such as interest paid on the purchase of appliances
§ Painting
§ Pest control
§ Repairs
§ Supplies
§ Taxes – real estate and rental taxes
§ Utilities
In order to deduct mileage a written record of the mileage related to the operation of the rental property needs to be maintained. For 2005 the mileage has been increased from 37.5 cents to 40.5 cents per mile. Activities that fall into the range of property related expenses are collecting rent, performing or supervising maintenance work, checking on the condition of the property, and running errands for the property.
A taxpayer can take depreciation for a personal computer used in managing their rental activities; of course they will need to keep a written log of the time the computer is used in managing their rental property. If a computer is used less than 50% for business, the depreciation must be computed using the straight-line method over five years. If over 50%, a Section 179 deduction can be taken based on the percentage of use. Section 179 allows taxpayers to deduct qualified equipment in full up to $100,000 (adjusted for inflation) in 2004 and 2005. Cell phones expenses can also be deducted using this same approach.
Repairs and maintenance are expenses that can be confusing in the nature of their deductibility. It is important to distinguish between items that are recurring in nature and considered normal repairs and items that last longer or improve the values or life of the property. Expenditures that rehabilitate, modernize, and improve the property must be capitalized and depreciated.
The cost of the property, less land, is depreciated and deducted each year. In most cases, depreciation causes a loss on rental activity. Nevertheless, like all good things, there is a catch.
In the year of the sale, the depreciation taken reduces the cost basis of the property and increases the gain realized. Generally, the gain due to depreciation is taxed at a maximum of 25%. When reporting the sale of property, the taxpayer must first calculate the gain resulting from depreciation recapture. Any remaining gain is capital gain as long as the property was held for more than one year.
If a taxpayer uses a home office, they can deduct the expense on Schedule E. The space used must be exclusively and regularly used as the principal place of business. The home office can be a separated structure from the home such as a detached garage. If the rental is set up as a corporation and the shareholder is an employee of the corporation, the business use of the home must be for the convenience of the employer. In this case the employee takes the deduction for the office-in home on schedule A.
“Tax Tips” are the opinions of Executive Accounting Solutions, which is not a substitute for individual accounting, tax, and professional services since individual situations vary.