This 10 page article was presented by the author, Mark Pelersi, Attorney & CPA, at the February 2009 CDARPO meeting. It is presented here in “MS Word” format, with permission, for the benefit of our members and readers. Questions regarding the content should be addressed to Mr. Pelersi. A copy of the original document can be downloaded from the following link only with the permission of the author.
Taxes from the Landlord’s Prospective
Mark S. Pelersi Attorney And CPA
1568 Central Avenue – 2nd Floor Albany, New York 12205
Tel: (518) 782-2511 Fax: (518) 220-1444 firstname.lastname@example.org
February 12, 2009
TAXES FROM A LANDLORD’S PERSPECTIVE
I. Getting Ready. Keeping track of your information for your taxes.
1. Generally, whether you are an individual owner, joint owner of a piece of property, a small partnership, a sole or multi member LLC or if you hold your property in an S Corp. you must keep track of your income and expenses on a property by property basis. In addition you must also keep track of your income and expenses based on the category of the item. For the income side this is usually easy (i.e. rents) but on the expense side you must separately track and tally advertising, rental commissions, property and school taxes, utilities, repairs and supplies, etc. If your repairs are extensive (assuming they are not improvements) it is also a good idea to separate them into plumbing, carpentry, roofing repair, etc. instead of just the “repair” category.
2. Substantiation is all important to preserving your deductions in an IRS audit!
3. Use a rental checking account, which is separate from your personal checking account or a charge card for all expenses. It is suggested that you write the check number on your receipt and the property and expense description on the check as well as your check register. If you are also keeping a summary spread sheet for each property enter the check number, date of the check, payee, amount of the check and place the amount in the column for the proper expense.
4. Put all rental income in the rental checking account and keep a separate spreadsheet (per property and preferably per unit) with rental payments. The IRS may also ask to see your personal checking account especially if the rents deposited to the rental account don’t agree with your leases and vacancy records. I suggest that you also require your tenants to pay the rent by check or money order. If a tenant pays with cash give the tenant a receipt and enter the cash payments, in your rental income records. A rental spreadsheet, besides providing a summary and documentation for tax purposes will also assist you in identifying tenants who may be behind in rent
5. Pay all rental bills from the rental checking account or by credit card. When not paying by check, use a charge card instead of cash and at the end of the month, write a check from the rental checking account to pay the rental expenses on the charge card. A dedicated rental charge card is also a good idea. Remember to break out the charged expenses per expense category and property on your check register and expense summary. Attach a detail sheet to the charge card statement which allocates the various charges to expense categories and then transfer these final numbers to your expense summary spreadsheet.
6. As a time saving device have your bank automatically pay recurring bills (i.e. mortgage payments, National Grid, trash pick up) through on-line banking. Be sure to post these expenses to your expense summary by expense category and to deduct them on your tax return. You usually do not need to post mortgage payments as you will receive a 1098 from the bank showing the interest paid.
7. Try to avoid paying expenses by cash. If you must do so get a receipt. Mark the type of expense and the property involved on the receipt as well as the date and person paid if not on the receipt. Again, be sure to enter your expense in your expense summary spreadsheet. Be sure to put the receipt in your property subfolder for tax preparation time.
8. You must report each property separately on 1040 Schedule E. Besides the records in your checkbook set up a file folder for the receipts for each property. At the end of the year put these file folders with your tax information and open new file folders for the new year. This will support your deductions in an audit.
9. Categorize the expenses. Use a manual spreadsheet or a computer spreadsheet to tally each separate expense for each property for the year. This way at the end of the year all of your utility bills, trash bills, advertising expenses, etc. for a particular property will be in separate columns on your spreadsheet and will be easy to tally and put on Schedule E. Your schedule E expense amount should agree with your spreadsheet if you are using one. If you are not using one the schedule E expense should agree with your receipts, checks and check register and credit card records for that expense. Your receipts, checks, check register and credit card records should also support the expense amount on your spreadsheet if you use a spreadsheet. If you have a number of receipts for one expense category, especially if you have not posted an expense spreadsheet in an ongoing basis I suggest stapling the receipts together that support the expense along with an adding machine tape showing the total that support the expense category on schedule E. Pointing the IRS agent to a stack of receipts with an adding machine tape that agrees to the amount on Schedule E is extremely helpful in and audit.
II. Tax Rules for Real Property Rentals.
1. Accrual v. Cash Basis. Most taxpayers including most small or smaller landlords are cash basis taxpayers who report their taxes on a calendar year. This means that rents actually collected in a particular calendar year are reported as income and expenses actually paid in the year are reported as expenses. Accrual basis taxpayers must match the income and expenses to the year incurred or earned.
2. Expenses. Items that are consumed or wear out in a short period of time (usually less than one year) are written off as expenses. Repairs are also written off as expenses. A repair is an expense that keeps property in an ordinarily efficient operating condition. Repairs include repainting, masonry pointing, fixing leaks, plastering, coating gutters and roofs, and other similar items. The cost of replacing shingles and doing other needed repairs to prevent or eliminate leaks on a roof is now a repair expense. Cases have now held that the cost of removing and replacing roof covering materials is a deductible expense and does not need to be capitalized. The “repair” cannot significantly increase the value of the whole building, make it adaptable to another use or prolong the life of the property. Other expenses related to the rental activity such as, insurance, tax preparation fees, travel costs, rental commissions, etc. are deductible in the year paid.
An improvement or addition must be depreciated over the life allocable to the asset (39 years or 27 ½ years). This is true even if you improve the property or put an addition on the property after you have owned it for 10 years. The addition or improvement must still be depreciated over the applicable term (39 or 27 ½ years) for the type of property.
3. Capital Expenditures. Most capital expenditures must be depreciated, but Land cannot be depreciated. A value must be allocated to land upon the purchase of rental property.
? Land Improvement such as sidewalks, fencing, landscaping and shrubbery can be depreciated over 15 years.
? Nonresidential buildings must be depreciated using straight line depreciation over 39 years.
? Residential buildings must be depreciated using straight line depreciation over 27 ½ years.
? Furniture, appliances, window treatments and carpet used in residential rentals can be depreciated over 5 years. (MACRS or straight line)
? Computers, automobiles, light trucks and office equipment must be depreciated over five years (MACRS or straight line).
4. Passive Activities. With limited exceptions, all real property rental activities are passive activities for tax purposes. These rental activities are reported on Schedule E of the 1040 tax return.
5. Income Classes. The tax rules are complicated but generally you have earned income (income from wages, a sole proprietorship business, sales commissions, etc.), portfolio income (interest, dividends, gain or loss from income producing or investment property [sale of stocks or non rental property] not derived in the ordinary course of a trade or business) and passive activity income from a trade or business investment in which you do not materially participate, (limited partnerships and most rental activities).
BUT Rental of real estate is a passive activity EVEN IF the taxpayer materially participated unless the tax payer is a real estate professional. (see ¶ 10)
6. Material Participation. This category has a number of various time tests. The ones that qualify most landlords as materially participating in an activity is a) the taxpayer is the only one who substantially participates in the activity (does the work, rents the property etc.); b) the taxpayer spends more than 100 hours participating and no one else spends more hours or the taxpayer spends more than 500 hours participating in the activity during the year.
Keep in mind that even if you meet the Material Participation test, rental of real estate is, by law, considered a passive activity. If you engaged in some other type business and met the Material Participation test that business would not be considered a passive activity and any loss would be fully deductible against other income.
7. Passive Activity Rules Impact. The practical impact of these passive activity rules is that passive activity losses are limited to passive activity income. What this means is that losses (hopefully only paper losses) from a rental property can only be offset against other rental income or other passive income such as that from a limited partnership.
You can carry passive losses not deducted forward to future years when the property (due to increased rent or lower expenses) becomes profitable and use the carried forward passive losses to offset the future passive income. Generally, the losses are also deductible when you sell the property.
BUT there is a special rental loss deduction up to $25,000.00 per year for landlords if you qualify. (See #8 following)
8. Special Rental Loss Allowed. A $25,000.00 special loss allowance for rental real estate is a limited concession to landlords. Up to $25,000.00 of passive losses from rental real estate can be deducted each year against income from non-passive sources, such as wages or portfolio income. The following rules apply:
a. The taxpayer (or spouse) must “actively participate” in the rental activity. Active participation standards are met if the taxpayer and spouse own at least 10% of the rental property and have substantial involvement in managing the rental.
Note: Active participation is a lower standard of involvement than material participation under passive activity rules. This means, for most of us, that the active participation test is the only test we need to meet.
b. A limited partner cannot meet the active participation test.
c. The amount of loss eligible for the $25,000.00 allowance is determined by netting income and losses from all of the taxpayers rental real estate activities in which the taxpayer actively participates.
d. The $25,000.00 special loss allowance is phased out by $.50 of each $1.00 amount of the taxpayer’s modified adjusted gross income over $100,000.00 for single or married filing joint. Thus, the allowance is reduced to zero when modified adjusted gross income reaches $150,000.00. IRS From 8582 is used for computing and reporting the phase out.
9. At Risk Rules and Grouping Rules. In addition to the passive loss rules, in order to deduct a loss from any activity, you must have an amount at risk. If you have no investment in a property and all non-recourse financing you have no amount at risk. You are not entitled to deduct any loss on your income tax return from that particular property. Grouping rules may also limit losses when a property is sold. Landlords have the option of treating each property as a separate activity (probably the preferred method) or grouping various properties or all properties into one activity. If properties are grouped into one activity and one of several properties is sold with accumulated passive losses, the passive losses cannot be recognized until the entire group of properties is sold (or the group has profits to offset).
10. Real Estate Professional. Rental activities in which you materially participated during a tax year are NOT passive activities IF for that year, you were a real estate professional. If you qualify as a real estate professional, losses from these rental activities are not limited by the passive activity rules (you can deduct the total loss, not just a $25,000.00 loss against other income).
a. For the status of real estate professional, each interest you have in a real estate activity is a separate activity unless you chose to treat all interests in real estate activities as one activity. If you group the activities you could run the risk set forth above at paragraph “9”.
b. You qualify as a real estate professional for the tax year if you meet BOTH of the following requirements:
1. More than half of the personal services you performed in all trades or business during the tax year were performed in real property trades or businesses in which you materially participated.
2. You performed more than 750 hours of services during the tax year in real property trade or businesses in which you materially participated.
c. You cannot count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer.
d. If you file a joint return you cannot count your spouse’s personal services to determine whether you meet the two requirements listed above. However, you can count your spouse’s participation in an activity in determining if you materially participated in that activity.
e. Real Property Trades or Businesses. A real property trade or business is a trade or business that does any of the following with real property.
? Develops or redevelops it.
? Constructs or reconstructs it.
? Acquires it.
? Converts it.
? Rents or leases it.
? Operates or manages it.
? Brokers it.
III. Property Acquisitions.
1. Generally all of the cost to acquire a property and make it ready for occupancy must be depreciated with a deduction for the value of the land which cannot be depreciated. This includes all of your usual expenses of closing such as title insurance, attorney’s fee, bank fees, filing fees and mortgage tax. This ALSO includes fix up expenses if the property is not held out for and available for rental.
IV. Disposition of Properties. Properties are usually disposed of by selling the property but can also be disposed of by swapping or exchanging the property.
1. Depreciation recapture is the provision that allows the government to impose a tax when a property is sold on the depreciation that was deducted each year against ordinary income.
Depreciation recapture rules are complicated but here are some guides.
a. Property held for less than one year. All depreciation is recaptured as ordinary income.
b. Nonresidential rental property put in service after 1980 and before 1987; all depreciation is recaptured as ordinary income.
c. Residential rental property placed in service between 1980 and 1987. Depreciation in excess of the straight line depreciation (accelerated depreciation; then allowed but not now) is recaptured as ordinary income.
d. After the accelerated depreciation (that amount over straight line depreciation) is recaptured as ordinary income the balance of the depreciation remaining (or all of the depreciation if the straight line depreciation method was used) is called unrecaptured Internal Revenue Code Section 1250 Gain. This gain, which usually represents the straight line depreciation deducted over the years is taxed at your regular tax rate subject to a maximum rate of 25% should your tax rate meet or exceed 25%.
e. The balance of the gain after deducting what is left of your basis in the property, the accelerated depreciation, if any, and the straight line depreciation is taxed at your applicable long term capital gains tax rate (assuming you held the property for more than one year), now 15%. (The long term capital gains tax rate is 0% for individuals who are in the 10% or 15% tax bracket).
V. Miscellaneous Tax Items.
1. Business mileage rate (January 1, 2008 – July 1, 2008 – 50.5¢ per mile; September 1, 2008 – December 31, 2008 – 58.5¢ per mile). You can always deduct the actual expenses of your vehicle used in a rental activity.
2. Records. Keep tax return copies forever. Keep backup for income and expenses for seven years. Keep information regarding the basis of rental properties (purchase contract, closing statement, improvements) until the property is sold and then keep this information with the tax return for the year of sale for an additional seven years.
3. If you bought rental property during the year of the audit the IRS will want to see your purchase contract, closing papers, depreciable basis calculation and information when the property was available for rental.
4. Too much depreciation may lead to imposition of the alternative minimum tax as before.
5. Even though it’s called “interest” or “property and school taxes” if the expenses relate to rental property they are subject to the passive loss rules.
6. Be sure to put security deposits in a bank account separate from your own funds. I suggest that each tenant have a separate passbook account (these are available at Trustco and, I believe, Pioneer and perhaps Citizens Bank) which passbook is placed in the tenant’s lease folder.
©Copyright 2009 Mark S. Pelersi