To Real Deal on Owning Rental Real Estate

Owning Rental Real Estate comes with a lot of misunderstandings.  This conversation talks about what it really means so you understand the rules prior to making the significant purchase.

Transcript

SPEAKER_00 0:04

Hi friends. Welcome to this episode of TIF Talks Tax. I'm your host, Tiffany Albright Rankin. In this conversation, we're going to be talking about rental real estate and understanding what it means to own it. But before we start, let me tell you a little bit about myself in case you were wondering. I'm a licensed CPA in the state of Ohio, and yes, I do bleed scarlet and gray. I am the privileged owner of a boutique firm in Central Ohio called the TLA Group, where we specialize in all things tax, tax compliance, tax planning, and tax consulting. Our fundamental goal at the firm is simple. We're here to help. One of the ways we can do that is by empowering you through these casual conversations. So let's talk. Hi, friends. Happy Memorial Day. I hope that wherever you are, you're having a nice long weekend. Here in Ohio, we are um boating in our yards because of so much rain. Um that's my attempt at a joke. But anyway, I hope you're having a nice weekend and thank you for tuning in for this conversation. So, this one, as I said in my previous uh conversation last week, we gathered a lot of information about good topics to talk about during tax season. And one of them we've always been wanting to talk about and certainly hit home this time, relates to real estate, specifically rental real estate. There is a lot of misunderstanding out there about what it actually means to own rental real estate and what you can do with it. So I thought this would be a good con a good time to have a conversation to kind of debunk uh the misnomers out there and kind of set you straight on what it actually means and how it functions to own real estate. So let's get started with the conversation. First off, we're gonna be talking at a very high level today. And many of the things we're going to be talking about, we're just again gonna go into high level so that to get into the detail of it would be outside of the 25 or 30 minutes we're gonna have this conversation. But definitely the goal here is to is to help you understand what it actually means, possibly answer some of your questions, questions, and then lead you more into being able to talk with your professional about what this actually means for you. So during the course of the season and really throughout the year, more times than not, we will get convert, we will get phone calls or emails from um either current clients or prospective clients saying, we're looking at buying a piece of rental real estate or we're looking at buying a vacation home so that we can lower our taxes. So if this is you, I want you to listen in. If you're one of those that is saying, oh, I pay so much in tax, I'm trying, I want to lower our income so that our tax isn't so high. We're gonna buy real estate. We're gonna buy either a vacation property or we're gonna buy a rental so that we can get a tax write-off. So that's where we're gonna start our conversation. That isn't necessarily what's going to happen here, at least immediately in the current tax year. So that's when I come in and I A, congratulate the client for thinking about, you know, purchasing real estate. And then we talk about what that actually means. So let's do that now. The first thing we're going to talk about is before we go in and purchase our either vacation property or a piece of rental real estate, we're going to talk about owning your own home. Owning your own home, as many of you do, um is a beneficial asset, probably one of your largest assets. Because, as we know, real estate is one of a few assets that typically appreciates in value, meaning its value grows over time. That's a good asset to have. So, what I want to start with very quickly is what it means to own your own home and then either turn it into a rental later or sell it. Under the current tax law, under section 121 of the Internal Revenue Code, there is a gain on home sale exclusion. And again, we're going to be talking about a married couple, but if you are not married, you can divide that in half. So, under the current rules, under section 121, with your primary residence, the home that you live in, as long as you have lived there two out of a five-year period. You've lived there, it's your personal residence, and you own it. So the use test and the ownership test, two out of five years. To the extent you have a gain on the sale of your principal residence, you can exclude up to $500,000 of capital gain on the sale of your primary residence. If you've lived there out of every two out of five years, you can exclude up to a half a million dollars of gain. I say this first because that is something to keep in mind from a planning standpoint as far as owning real estate and being able to continually not have to pay tax on the gain on the sale. So keep that in mind. Now that you have that tucked away, let's talk about owning rental real estate. We're first going to talk about just regular real estate, so not a vacation property, just real estate like a single family unit or units that you are going to be purchasing and renting it out on a long-term basis. We're going to start with that. Definitionally speaking, unless you are a real estate professional. If you are a real estate professional, these won't apply to you. But if you're just the normal person that wants to buy a piece of real estate or a couple pieces of real estate, you probably are not a real estate professional. You wouldn't qualify. So generally speaking, the rule is real estate is considered a passive activity, not an active activity. Passive activity. And what does that mean? Passive activities mean that they can only be netted with other passive items. So if you generate loss from the sale of your, or I'm sorry, from the rental of your real estate, that is going to be considered a passive activity loss. And you know we love our acronyms. The acronym for a passive activity loss is PAL, PAL. So many times people come to me and say they are going to buy a piece of real estate so that they can create losses to lower their income. If you are not a real estate professional, which you likely aren't, that loss is going to be considered a passive activity loss. And losses from passive activities can only be netted to offset passive income. Apples to apples. If you are generating passive losses from the rental of your real estate, which you likely will in the first couple years because of depreciation, because of mortgage interest, because of real estate taxes, because of repairs, because of all the expenses that go along with renting the property, you likely will have a loss. And under most circumstances, if you only have a passive activity loss and you have no passive income to offset that, you will not be able to take your loss in the current year. I know. Buzzkill. Now you don't lose the loss, it just gets suspended and carried forward for you to use in future years when you generate income from passive activities or ultimately when you sell the property. Before we go into the exceptions for that, let me tell you what my opinion is on the way that you should consider owning real estate, whether it be a rental or whether it be a vacation property. Owning real estate, the way you should think about it, in my opinion, is not to receive a current tax deduction for it, but rather a means to diversify your investment portfolio and owning an asset that appreciates in value, i.e. real estate, and renting it out on an annual basis. Hopefully, the goal here is that it cash flows itself. So you make the initial investment and you get tenants in there to rent the space. And the rental income that you are generating from the property will cash flow the expenses, the cost it and expense incurred to maintain the property and own it. Meaning you do not have to come out of pocket initial dollars to own the asset that will appreciate. So that in the future, when you retire or at some other point, you have purchased an asset that will appreciate that has cash flowed itself, that in the future, when you sell it, you can offset the gain from that with all of these losses that you have created through the years owning it to limit your gain. Think of it like capital losses or loss harvesting, if you will. My thoughts on owning real estate are that again, you own an asset that will appreciate in value, that hopefully you are getting tenants in there to cash flow it through the years so that in the future, when you do sell it and realize a large gain on it, you can offset it with the losses that have been suspended during ownership, the PALs, the passive activity losses, that in the future will lessen your gain. And you are thinking, oh, okay, that wasn't really what I was thinking was going to happen here. And I understand that. So let's talk about some exceptions to the rules. The first exception to the rule is if you actively participate in the property, meaning you make management management decisions, you handle the repairs, you are doing the banking and the accounting and all the things. If you own a piece of real estate and you are actually actively involved in it to some level, you're making management decisions, then there is the first hurdle that you can cross called active participation. To the extent you or your spouse have actively participated in the property, you do have the ability to potentially deduct up to a $25,000 per year loss from the passive activity. So you're thinking, okay, well, why didn't you just say that from the get-go? I know. I didn't because I have a caveat with that. There's an income limit. I wanted you first to understand that real estate in itself is a passive activity, and generally speaking, you can't deduct the loss in the current year. But if you meet the active participation rules, there is the ability to deduct loss up to $25,000. But there is an income limit. And that income limit, for the most part, is fairly low. To the extent your modified adjusted gross income is between $100,000 and $150,000, you will not your $25,000 up to a $25,000 deduction will be phased out, reduced, and brought to zero to the extent your modified adjusted gross income is above $150,000. And so what I say to a lot of my clients in this situation who come to me and say, we're going to buy real estate so that we can lower our income because our income is so high. I say to them then, sure, you might actively participate in this, but the fact that you are saying to me you want to lower your income because it's too high. So you have the money or the means to buy a piece of rental real estate or a vacation property generally means that your income, your modified adjusted gross income is above $100,000 or $150,000. So you aren't going to be able to benefit from this loss, this active participation $25,000 deduction. So let's talk about an example. I have an example here where husband and wife um want to purchase a piece of rental real estate. And so they do that and they purchase a property at $500,000. They get it ready and they rent it. So they purchased a property for $500,000 and they get they have a tenant, so they are renting it. So it is in large part cash flowing itself. In the first year, they create a $15,000 passive activity rental loss. And they meet the active participation rules because they're actively involved in it. Um, they're handling the annual uh management decisions related to the property. So definitionally speaking, they meet the rules of active participation and have created a $15,000 passive loss related to the rental. Now we go and look at what kind of income they have. In example one, husband and wife have $250,000 of modified adjusted gross income. Because their income is above $150,000, they will not be able to utilize any of that $15,000 passive activity that passive loss from the rental in the current year. Doesn't mean they they lose it, it just gets suspended and carried forward for future use. So while they do meet the active participation rules, their income is too high to be able to benefit from the loss. So it gets suspended and carried forward. Now, let's change the facts in this example. And this year, the taxpayers, husband and wife, their modified adjusted gross income is $90,000. Maybe they retired, maybe they have a loss from somewhere else, a business that they're able to use. Who knows? But collectively, their modified adjusted gross income is at $90,000. They still have the rental that created a $15,000 passive loss, and they actively participate. Because their income is at $90,000 below $100,000, they will be able to take the full $15,000 loss on the rental activity. So it is possible to benefit from the loss, but it's income driven. The second exception that you might be able to cross to be able to deduct your rental loss is something called material participation. And material participation is a higher threshold that needs to be analyzed on an annual basis. To the extent you qualify for material participation, then your activity is not deemed as passive. It's deemed as active. And if you have a loss, you are able to deduct it. You do not have to have passive income to offset it. It can go ahead and reduce your wages, your interest, your dividend, any other items of income. There are seven events that the IRS has laid out that would qualify you as a material participant in that activity. You don't have to meet all seven events. You only have to meet one of them. We're not going to go through all seven of them in this conversation because, again, we try and keep this message, this conversation short and sweet. But I will talk about the first three that are kind of the most common that people can qualify for. You could qualify for material participation if you spend more than 500 hours on the rental activity. 500 hours. That's a lot of hours. If you do substantially all of the work yourself, so you you function as the jack of all trades in this. You don't hire out a lot of the work in the property. Or you spend more than 100 hours on the activity, and that is more than anyone else associated with the activity. So again, this is a year-by-year decision, and it takes a careful examination of the time spent on the property. And if you meet that hurdle and you are considered to be a material participant, then it is not passive and you are able to deduct the loss on the property. So something to consider. Okay. That is talking about just your general, you know, rental activities. You buy a piece of real estate and you rent it. If you create loss, initially you aren't able to deduct the loss. You can look to see if you meet the active participation rules. If so, then you look at your income level to see if you can deduct any of the loss. You also look at your hour requirement, your hour level to see if you meet material participation. And to the extent that you do, it won't be passive and you can deduct the loss. There are also grouping elections that fall into there that you can, if you have multiple, like a cluster of real estate activities going on, there is the ability to make elections to group them together. That is beyond the scope of this conversation. But generally speaking, that's how rental property operates. Now, one thing to keep in mind as you are renting this property out, you are depreciating the property. As you are depreciating the property, that is in essence writing off a portion of the purchase price. So remember that as we talk about losses and gain exclusion and whatnot related to this asset. Now we want to move on to a vacation home. So many of you are saying, I want to buy a vacation home in a spot where we like to vacation and then use it throughout the year, but also rent it so that I can cash flow it. Great idea. Let's talk about how vacation homes work. Before we talk about how a true vacation home works, we want to talk about the 14-day rule. This is actually perfect timing in this conversation here in Ohio, specifically central Ohio, as we are coming upon the memorial tournament. So many of you have probably heard of the 14-day rule. That's the real name of it, the 14-day rule. Some people call it the memorial rule. Some people call it the Augusta rule or the master's rule. Some people I've heard it called the Eisenhower rule. What that says, if you own a piece of real estate, including your personal residence, that you rent out for 14 days or less during the calendar year. 14 days or less during the calendar year, it is a non reportable activity. You do not have to report the income that you the money that you received from that 14 day or less rental activity. So an example is here in central Ohio, we have the Memorial Golf Tournament coming up soon. Many people that live at the golf course, Mirfield, where the where the event is held, they rent out their house to either golfers or corporations for events during the tournament. And typically that is less than 14 days. So to the extent you do that, any income that you receive from the rental of your property, whether it be your personal residence or some other piece of real estate, if you only rent it out for 14 days or less during the calendar year, you do not have to report any of the income. So that's a win. Bonus. Now let's move into if you own real estate, not your personal residence, but if you own real estate and you rent it out for more than 14 days. So the threshold then becomes, we call that mixed use. So if you are using it both for personal and for business, we are going to be limited on the amount of deduction we can take to offset the income. So the next step will be we need to look at how many days we rented it during the year at fair market value. So not the friends and family discount, but true fair market value. Whatever those numbers of days are, you multiply that by 10%. And whatever is larger, either the personal use days or 10% of the fair market value days. So let's say you you rented it out for 200 days at fair market value, 10% of that is 20. So as long as you used it for personal use less than the greater of that day, whether it be 20, 20 days or 15 days, all of the expenses associated with renting the property can be deducted. You don't have to limit it. But let's say in this example, you used it for personal use, so your own family personal use plus other friends and family. Collectively, you used it and did not rent it out for fair market value 30 days of the year. Then we have to prorate the amount of deduction expenses associated with renting the property. And what that means is you are only going to be able to deduct in large part the expenses associated with the true rental use of the property to equate to the rental income generated from that. So if you fall into the mixed use category and you used it more for personal than the math says on the rental, the rental component of it, you are only able to take deductions associated with the property that wipes out the rental income. So if you're following along here, that would mean that you are only going to be able to net to zero in any given year. Now, to the extent you have expenses that were suspended because of the personal use days, a portion of those can be carried forward and offset again against net rental income in the future. But again, if you say to me that you are going to purchase a piece of property and use it as vacation, my red flags go up and say more times than not, you are not going to be able to get a deduction for that in the current year. The best you're going to be able to do is cash flow that thing and wipe out any income associated with it so you aren't paying any tax on it. It is not going to generate a loss for you if you use it more for personal than mathematically is allowed on the either 14 over 14-day rule or 10% of fair market value rental days. So then you say to me, Oh gosh, you're just killing me here. On again, my ability to lower my income in a current year. And my answer to that again is yes. Let's then go back to what I said initially. Owning rental real estate should conceptually be thought of diversifying your investment portfolio to own an appreciated asset for the future. And hopefully it cash flows itself by way of renting it during your periods of ownership. Um, so that eventually when you sell it or turn it into something else, you can lessen your gain because of all of the suspended losses that you've accumulated during ownership. So let's round this out with talking about planning opportunities around owning your rental real estate. One of the things that you can do is something called a light kind exchange. And in a light kind exchange, real estate under the current tax law is the only asset left that you can light kind exchange. So what many people do in when they own rental real estate is they they do something called a 1031 exchange. And an example of that would be you own a rental property, it is appreciated in value, um, you would like to sell it and and buy another piece of real estate. So basically kicking the can down the road. To the extent you own rental real estate and you sell it and within a certain period of time reinvest it into another piece of real estate that is going to be income producing. To the extent you do that, you are able to defer the gain on the piece of that real estate. It is a very useful tool if you want to stay in the real estate game to defer recognition of income. It is a very helpful tool. Now, you cannot do it on your principal residence. Many people say to me, Oh, well, I'm gonna sell my house at a gain, and I want as long as I reinvest that into a new house within 45 days, I don't have to pay gain on the property. That is not true. You cannot do it on a on um your personal residence. You also cannot do it on a piece of strict vacation property, one that is not income producing, one that you are not renting. If you have that on the personal residence, you look to the two out of five year half a million dollar rule for gain exclusion. If you don't have that, then the light kind exchange rules do come into play. Now we aren't going to go into detail of light kind exchanges. That's for another conversation. But know that that is helpful. Another thing that is helpful is that real estate, like many other assets, gets a stepped up basis at death. So many times if you own real estate that has appreciated in value, you will want to hold on to it or continue to like kind exchange and then die with it so that the basis in the asset gets a full step up at death, and whoever is inheriting that property can then sell it and reap all of the appreciation in that asset without having to pay any gain on the sale. So keep that in mind. Another tool that is helpful, if you remember, we started the conversation with section 121, the home sale gain exclusion. Remember, as long as it is your principal residence, to the extent that you live out of it, two out of five years, you can exclude gain from the sale of your principal residence up to a half a million dollars on a married filing jointly basis. So here is a planning tool related to one of the properties that you are currently owning and renting. Let's say you have your principal, let's say you you bought a rental property and it is cash flowing itself, it is appreciating in value, and you are renting it out. And you own a principal residence. A planning technique, now this takes a lot of planning and a timeline. Like you actually have to plan this out. Let's say you have this and you sell your principal residence and you met the two out of five year rule, and you can exclude up to a half a million dollars of gain on your property. Now, let's say you pick one of your pieces of real estate that you like and you move into that house and you turn that into your principal residence for two out of five years. The clock gets ticking on the day that you move into that property and turn it into your principal residence. As long as you own that for two out of a five, oh own and use it as your principal residence out of two out of five years, you can exclude another half a million dollars of gain. Now, you can keep doing this to realize significant tax-free appreciation out of those properties. Many people do this with their vacation homes or other pieces of real estate that they own. It takes a lot of planning and develop a timeline to do this. Now, one caveat that I want to put in here, and this is a fairly new, unfavorable provision in the tax code. Now, when I say fairly new, it's probably 15 years old. But in the world of tax law, that is fairly new. To the extent you have a piece of rental property that you have taken a depreciation deduction for, you have made it be income producing. You have tainted that as a rental property, meaning to the period that you used it as a rental, it were it will forever be um signified or identified as a rental property. And you need to carve out that period of time, meaning depreciation, for the period that you treated it as a rental. So if you have that and you move into it and turn it into your principal residence for two out of five years or more, and you then sell it and have a gain on that property, you will not be able to exclude the full amount of gain from the sale of that property because you treated it, you had it as a rental for a certain period of time. You will only be able to exclude a portion of the gain from the sale of that property. Now, maybe it's a significant portion of a gain from a sale, but because at some point you were using that property as income producing, it will forever be colored in that light. And you will have to recapture the depreciation taken during the period you held it as income producing, i.e., a rental. So that was a lot to cover in our short conversation. I hope that it shed some light on what it actually means to own real estate. It is definitely a worthwhile endeavor as far as your overall investment picture. And possibly, depending on how involved you want to get with the real estate, it might actually end up being considered a material participation where these and where these passive activity rules don't come into existence. But with careful planning, you can really maximize your investment in these properties, both from an appreciation standpoint and from a tax outcome standpoint. Okay, okay, folks. That's all I have for today. I'm going to move on to Memorial Day festivities. I hope that you enjoyed the conversation and you have a great rest of your day. We'll see you later. Bye.