What Your CPA Wants You to Know
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What Your CPA Wants You to Know
65. Rental Income: The Details to Know About Property Investments, Taxes, & Deductions
This episode is a must-listen for anyone who owns rental properties or is contemplating a jump into the market. We discuss why your new rental property won't instantly wipe out your tax bill, despite popular belief. We go over all deductible expenses and educate you on the subtleties of depreciation, all to prepare you for making savvy investment choices.
Wrapping up, we dissect the tax deductions associated with different types of real estate involvement. Whether you're a passive investor, actively managing properties, or aiming for the coveted real estate professional status, we clarify how each impacts your ability to manage tax liabilities. Our goal is to make complex tax and accounting concepts understandable!
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So you're saying that if you buy a $200,000 property, which is kind of cheap right now, then you don't get to deduct that $200,000.
Speaker 2:Unfortunately not. That would be great, right, we could all just never pay taxes. We just keep buying property every time we make money. We only keep enough to buy food and spend the rest on real estate, and then we never pay taxes until we have a real estate empire and we can retire. Wouldn't that be great?
Speaker 1:Yeah, that would be awesome.
Speaker 2:Welcome to what your CPA wants you to know.
Speaker 1:Tax and accounting help can be expensive, so we've created this podcast to help guide you through it all and make you feel like you have a CPA in your back pocket. I'm Carson Sands and I'm Taryn Sands.
Speaker 2:I'm a CPA with over 10 years of experience helping people start and grow their businesses.
Speaker 1:And I'm an MBA with a specialization in marketing and entrepreneurship. Taxes suck and we want to make sure you don't pay more than your fair share.
Speaker 2:We're here to share everything your CPA wants you to know in a fun and easy to understand way. Let's get started.
Speaker 1:Let's do it. Today's episode is all about rental properties, rental income and the taxes that you pay if you have any of that. So if you have rental properties, this is a good episode, because we're going to discuss things that we see our clients run into a lot. And if you're thinking, maybe you want to get into owning some rental properties, maybe having that Airbnb you've been thinking about, this is also a great episode for that, so that you know what you're getting into.
Speaker 2:So first let's talk about what is rent. Now, I know all of you know what rent is, but rental income can be something from many sources. Maybe you have some houses that you own that you rent out to people, or some commercial property that you rent to businesses, or maybe you own some property that you rent to your own business. You could also own equipment that you rent out, or you could even get rent for mineral leases that you own. But today we're talking about rental income from rental properties like residential rentals or non-residential commercial property rentals.
Speaker 1:So very basic. You have another home that's an investment home and you have someone leasing it out and they're paying you rent to live there. Very simple.
Speaker 2:Yes, very simple. So the way that it affects your taxes is not so simple. There's a lot of rules and there's just a lot of restrictions on what you can and can't do. You know, one thing we see a lot of is that people think they have a big year, maybe they sold something, maybe they sold a business, or maybe they just made a lot of money in a business, and the first thing they want to do is like, hey, if I go buy a rental property, then that will offset all that income that I made. And that's not the case. So rental property is a great investment. It's not always a great tax deduction, so don't get the too confused and go out thinking you can spend all the money you just made on an active business and not have to pay taxes on that.
Speaker 1:So you're saying that if you buy a $200,000 property, which is kind of cheap right now, then you don't get to deduct that $200,000.
Speaker 2:Unfortunately not. That would be great, right, we could all just never pay taxes. We just keep buying property every time we make money. We only keep enough to buy food and spend the rest on real estate, and then we never pay taxes until we have a real estate empire and we can retire. Wouldn't that be great?
Speaker 1:Yeah, that would be awesome and unfortunately, a lot of people do think that coming into this if they're going to own rental properties, and we've seen that a lot within the last few months. So that's why we thought this would be a really good episode to make sure that you know all the details.
Speaker 2:So if you know anything about real estate, you know that it goes up almost always and pretty much in perpetuity. So the IRS also knows this. They're not stupid, so they're not going to. Let you just take your $200,000 house that you buy and say, okay, a $200,000 deduction. It's not really fair, because they know that in 10 years that's not going to be worth less, it's going to be worth more. So how does it affect your taxes? Well, any income that you make on a rental property is subject to income taxes, just like any other income that you have Now. Luckily, in most cases it won't be subject to self-employment tax, because it's not that kind of a business. But you will have to be prepared to pay income taxes if you make a profit. Now, the good news that goes along with that is that most rental properties break even from a tax perspective because there are a lot of deductions that you can take against that income.
Speaker 1:And the other question what are these deductions? If I own a rental property, what can I deduct on my taxes from the rent that I get?
Speaker 2:So that would be anything specifically related to that house. It could be the mortgage interest on that property, the real estate taxes, hoa fees, insurance on the property and even utilities, if those aren't paid by the tenant or if you are paying the utilities out of pocket during a time when maybe the house is vacant. So, on top of that, repairs and maintenance on the property, cleaning fees, maybe even a PO box that you keep because you don't want your tenants to know where you live. That's a good idea, actually.
Speaker 1:And a lot of our clients have Airbnb, so they always ask if they can deduct that fee that they're paying, and the answer is yes.
Speaker 2:Yes, absolutely. You can deduct any commissions that go to booking sites. You can also deduct the management fees if you pay a property management company to oversee your rentals, and you can even deduct the mileage that you drive to and from to check on the property or to mail things or to pick up supplies for the property.
Speaker 1:So there's actually a lot that you can deduct. So if you have a small rental house and you're making, let's say, $2,000 a month in rent and you've only made $24,000 in a year, then your income isn't going to be that great.
Speaker 2:That's true. You will have plenty of deductions to put against all that. And on top of all those, you have the final one I want to talk about, which is depreciation. Now, depreciation is the way that you capture the expense that you pay for the house. Let's say that you pay $275,000 for a house. You have to depreciate it over 27 and a half years. So in this case you would get to deduct $10,000 per year as depreciation against that property. Now, we did mention commercial properties earlier. So if you have a commercial property that you're renting out to businesses, you actually have to depreciate it over 39 years. But for the meantime, let's talk about residential properties.
Speaker 2:Now, that depreciation is very important because there's a lot of issues that go here. It does help you get a deduction on your tax return and it helps you reduce that rental income, but it also reduces the cost basis of your property. Now, not to go into too much accounting lingo, but basically, if you spent $275,000 to buy the house and you depreciated over time, then that is decreasing the cost that you get to use later if you ever sell the house. So let's say you do own the house for 27 and a half years and you depreciate it all the way down to zero. Well, that was some great expenses you took along the way. But now, if you sell it for $275,000, you didn't break even. You have $275,000 of income from the sale of that property. So that's important to remember. So the next question people ask is well, I'm planning to sell it one day, so maybe I just won't depreciate it and that way I won't have to worry about it Turns out you can't do that. The IRS will reduce your basis in that property by the amount that you either did depreciate or should have depreciated. So make sure you depreciate your property like you're supposed to Go ahead and get the expense, because either way it's going to come back later as income.
Speaker 2:Now one more note on that. If you ever find yourself in that situation and you've owned a rental property for 10 years and you forgot to take depreciation on it or you just didn't know, there is a way to fix that. Reach out to your CPA. If they don't know how to fix it, then get a new CPA and then ask them how to fix it and they will help you. It's something that we do a lot. You don't have to go back and amend 10 years of returns. There's a trick to do. I won't go into all the details because you'll turn off the podcast if I do, just know that there's a way to fix it and we can help you do that, or a competent CPA can help you.
Speaker 1:So the lesson here is to definitely think about your basis if you're going to sell a property. Yes, it's very important and can you explain that in very simple terms so that people can understand what you mean when you say their basis?
Speaker 2:Sure. So let's go back to the same example. You buy a house for $275,000 but you don't rent it out, you don't depreciate it, it just sits there and then in a few years you sell it for $275,000. There's no tax on that sale because you sold it for the same price that you bought it for and so there's not a taxable gain. Well, if you bought a house that you rented out for $275,000 and you depreciate it for $10,000 each year, you're reducing that cost basis your original cost basis that you paid, by $10,000 per year. So even if you don't hold it for the whole 27 and a half years that it takes to depreciate it let's say you just have it for 10 years Well then you'll have reduced your basis by $100,000 and now your basis is only $175,000. So whatever you sell it for, you get to subtract now only $175,000 from that sales price to find out what your taxable gain is on that property.
Speaker 1:So your basis is very important with the IRS, because that's how they're going to determine what your profit is when you sell it.
Speaker 2:That's true. That's very important. So that's not exactly rental income or rental expense, but it is something that is very common with rental properties, and we don't usually see people buy these properties when they're 20 and then hold them until they die, which is the only time you wouldn't have to worry about the basis.
Speaker 1:So it's very important to understand at least the very basic part of that, because there is going to be consequences for selling it and you have to know what your basis is.
Speaker 2:That's true.
Speaker 2:That's the number one.
Speaker 2:Final thing, on the basis, since everybody loves not paying taxes anytime that they can get away with it, if you do have rental property and it goes up and value your entire life, even though you're depreciating it for tax purposes, there's only one way to not pay the piper on that in the long run with a taxable gain.
Speaker 2:That is to die. Now, I know it sounds like I'm joking, but that is the way you do it, and this is the way that wealthy families do some tax planning is that you hold all this value in real estate and maybe by the end of your life you will have real estate that you paid a million dollars for, but now it's worth four million dollars because it's gone up so much in value. Well, if you die, your kids inherit that and they get what's called a step up in basis. So their tax basis is not your million dollars or even your million minus what you took as depreciation. It's going to be whatever the property is worth the day you die. So if you don't need the money to live off of in your retirement, that's a great way to make sure no one ever pays a taxable gain.
Speaker 1:It's probably the best tax advice you've ever given on this podcast.
Speaker 2:Yeah.
Speaker 1:You want to save taxes? Just die. That's the secret, Okay.
Speaker 2:They say all things in life are no. What is it? They say that nothing in life is certain except death and taxes.
Speaker 1:But what they should say is If you die, you'll have to pay taxes.
Speaker 2:Yeah, death or taxes, because if you die you don't have to pay taxes unless your net worth is over 25 million dollars. So yeah, anyway, moving on. We'll do another episode on that, so let's not get too sidetracked.
Speaker 1:Do you want to start your own business but have no idea where to start? Does the tax and accounting part of business ownership scare you? Or maybe you just don't have the budget for CPA services right now? If this sounds like you, listen up. We've created a new business guide to help you through every step of the process so you feel confident and supported when starting your business. Our guide will help make sure you don't miss any important steps and educate you on the tax and accounting side of things. The best part is that it's priced for less than one meeting with a CPA, so don't ignore this part of the process.
Speaker 1:Use our guide to educate and empower yourself without the hefty cost of multiple meetings with the CPA. We will guide you through the initial steps, provide yearly checklist and give you things to put on your radar for the future as your business grows. And just for being a podcast listener, you get a discount. Find the link in the show notes to purchase the guide and use code podcast at checkout to use that discount. Now back to the show. Okay, so we did talk a little bit about basis, but we'll get back to what we're really talking about, which is rental income, and we want to talk about a few more fine details that are very important if you have rental properties.
Speaker 2:So If you make profit on the rental property, it's very simple, just like we talked about before your rental income minus all those deductions that we mentioned, including depreciation mileage, everything else. You take those expenses out and whatever's left is your income and you have to pay tax on that.
Speaker 1:That's really simple and that all will be filed on your personal tax return on Schedule E.
Speaker 2:Right Schedule E. Now where it gets more complicated is most rentals lose money, especially if you have a mortgage on it, especially if you have even a month of vacancy, because these rental properties operate at a pretty thin margin. So we do see losses on these rental properties all the time, and the way that you handle those losses can vary a great deal, depending on a lot of factors, and that's what we want to talk about next. So there's three levels of being a real estate owner. One is that you don't even actively participate. That's the lowest level and that just means that maybe you invested in a property with other people and you don't do anything. You literally just collect whatever net rent comes through. Or if they ever sell it, one day you'll get a little piece of that and hope it went up in value. That is completely passive investing and you don't get to take those losses except against other passive income.
Speaker 2:The next level is the more common one. What we're talking about here is you own a house and you rent it out, or you own some commercial property and you rent it out. This would be called active participation. It means that you manage the property, you deal with the tenants, or at least you deal with the management company that deals with the tenants, but you're still actively engaged in trying to make this a profitable endeavor. If that's you, then you could potentially deduct up to $25,000 of losses against your ordinary income, like from your W-2 wages or from your business. As long as you make under $100,000 on your AGI, then you can deduct $25,000.
Speaker 1:What if you make more than $100,000 on?
Speaker 2:your AGI. If you make between $100,000 and $150,000, you can still deduct some of those losses against your ordinary income, but not the full $25,000. It gets phased out as your income goes up all the way to $150,000 and then when you make more than $150,000, you don't get to deduct your rental losses against your ordinary income.
Speaker 1:If you're a high earner, this is not going to be that helpful for you.
Speaker 2:A lot of people think that there are these great deductions for real estate owners to use against their ordinary income, but the truth is there's not a lot of people making $58,000 a year and then owning a whole bunch of real estate that they can have lost, is it?
Speaker 1:Exactly that's what I was getting at.
Speaker 2:It does happen. Now we see people inherit property from parents that they ran out, or maybe they've just never made a ton of money, but they've saved well and that's what they've invested in and there's nothing wrong with that. It's just not something we see a lot of. In a lot of cases, people cannot deduct their rental losses.
Speaker 1:And then this third one. This is the big one.
Speaker 2:Yes, the third option. This is the one where you actually can deduct your rental losses as if they're non-passive income, meaning they're active income. You can deduct them against your wages, your business income, with really no limits. And that would be if you're considered a real estate professional. So there's a lot of rules in order to be considered a real estate professional.
Speaker 1:Yeah, it sounds great. Of course, I want to deduct all of this, you know, but the thing is not. A lot of people qualify for this and there's a lot of fine details. That makes it not so great.
Speaker 2:Yeah, it doesn't just mean you can read a Wikipedia page about real estate and go post a TikTok video about how smart you are in real estate and then call yourself a real estate pro. You actually have to follow some very specific rules that the IRS sets up.
Speaker 1:Yes, exactly. So what are those rules and who can actually use this?
Speaker 2:So the first rule is that more than 50% of your active working time has to be in real estate. So if you have a full-time job, this is almost impossible, because a full-time job is 2,080 hours a year and if you are saying that you spent more than 2,080 hours on real estate and you had that full-time job, that's not really believable. That doesn't leave very much time for sleep, so they're not going to believe that. The next rule is you have to spend more than 750 hours in real estate. Why do they have both rules?
Speaker 2:Well, a lot of people are retired.
Speaker 2:So if you're retired and you have multiple rental properties and then you don't have to have more than half of 2,080 or anything like that you have zero active work except for in real estate Well then you only have to have 750 hours or more per year dedicated to real estate and you're considered a real estate pro. So this could be people that manage properties full-time, or they're retired and they manage properties very actively up to 750 hours a year or more. Or this could even be real estate agents. Now that's who I really want to talk to, because if you're a real estate agent and you own two or three rental properties. You might not spend 750 hours on those rental properties, but that's not what the rules say. The rules say that you have to spend more than 50% of your time and more than 750 hours on real estate business. If you're spending more than 750 hours a year selling houses, then you're a real estate professional, so real estate property is an even better option for real estate agents than for your ordinary people that don't sell real estate.
Speaker 1:Yeah, so all of our real estate agents. That's pretty simple. They can fall into this category and we definitely recommend that they take advantage of this. But it's not going to be for somebody who has like $100,000 W2 saying, oh yeah, that's not my full-time job, I'm doing real estate.
Speaker 2:Right, Unless that W2 is well, you won't get one from. If you're a real estate agent, you'll get a 1099. But unless if that W2 is from a real estate related business, in which case you could claim to be a real estate professional.
Speaker 1:Right. You just can't be like managing Starbucks and saying that you're also 100% on real estate.
Speaker 2:Right, that's exactly right. So if you do that, then you can deduct your losses on those properties against all of your other income and you can have really bad years with really large losses and those aren't fun. But at least you can remember that, a the property is still going up in value, so you're still increasing your wealth in that way, and B you can use all of those losses against your ordinary income and you'll come out ahead.
Speaker 1:Basically, you can reduce your taxes from anything else on your tax return.
Speaker 2:Yes.
Speaker 1:So that's all we have to say on real estate and taxes. With that, if you know anyone that is active in real estate or looking to buy a rental or something like that, please send them this episode so that they can learn all this great tax advice.
Speaker 2:And until next time, thank you so much for listening to what your CPA Wants you to Know Podcast what your CPA Wants you to Know Podcast what your CPA Wants you to Know Podcast. This podcast is intended to provide accounting and tax information for educational purposes only. All tax situations are unique and should be handled with the assistance of a tax professional.