By: Kimberly Latoza, The Michael L. Larson Company, P.C.
Economic fallout from the COVID-19 pandemic caused some rental real estate properties to run up tax losses in 2020 and 2021, as tenants struggled to pay rent. If you're a landlord, you may have had to negotiate lease modifications that were unfavorable to you in order to help tenants. To make matters worse, more losses could be in store for this year. And high inflation isn't going to improve the situation, because it increases expenses for both you and your tenants.
Here are some important federal income tax considerations for rental property owners in the current economic environment.
Landlords can continue writing off the usual expenses related to operating a rental property, including:
Real estate taxes,
Building repairs and maintenance, and
Maintenance of outdoor areas.
For many rental property owners, a big tax-saving bonus is the fact that you can depreciate the cost of residential buildings over 27.5 years, even while they typically increase in value. You can generally depreciate the cost of commercial buildings over 39 years.
For example, suppose you bought a small apartment building for $1.5 million, excluding the value of the land. The annual depreciation deduction would be $54,545 ($1.5 million divided by 27.5 years). The deduction can shelter that much annual positive cash flow from income taxes. So, depreciation write-offs are convenient tax savers, especially if you own an expensive property or several properties.
Important: The annual depreciation deduction in this example would have been much lower if you'd purchased a commercial property, such as an office building or strip mall. These properties must be depreciated over 39 years, so the annual depreciation write-off for a $1.5 million commercial building would be only $38,462 ($1.5 million divided by 39 years).
Bonus Depreciation for QIP
The cost of qualified improvement property (QIP) placed in service by the end of this year is eligible for 100% first-year bonus depreciation. QIP is defined as an improvement to an interior portion of a nonresidential building that's placed in service after the building was placed in service. However, QIP doesn't include any expenditures attributable to:
Enlarging the building,
An elevator or escalator, or
The internal structural framework of the building.
Alternatively, you can choose to depreciate QIP over 15 years using the straight line method. That alternative might make sense if you expect higher tax rates in future years. Discuss your QIP depreciation options with your tax advisor.
Section 179 Depreciation Write-Offs
The 2017 Tax Cuts and Jobs Act (TCJA) increased the maximum Section 179 first-year depreciation deduction for qualifying real property expenditures to $1 million, with annual inflation adjustments. The inflation-adjusted maximum for tax years beginning in 2022 is $1.08 million (compared to $1.05 million for tax years beginning in 2021).
The Sec. 179 deduction privilege potentially allows you to deduct the entire cost of qualifying real property expenditures in the first year, above and beyond the first-year bonus depreciation that's allowed for QIP. However, Sec. 179 deductions are subject to several limitations, so ask your tax advisor before assuming you can take full advantage of this tax break.
The TCJA also expanded the definition of qualifying property to include expenditures for nonresidential building roofs, HVAC equipment, fire protection and alarm systems, and security systems.
Finally, the TCJA further expanded the definition of qualifying property to include depreciable tangible personal property used predominantly to furnish lodgings. Examples of such property include beds, other furniture, and appliances used in the living quarters of an apartment house.
If your rental property throws off tax losses, the passive activity loss (PAL) rules may come into play. Losses from rental properties will usually be classified as passive losses.
In general, the PAL rules allow you to currently deduct passive losses only to the extent you have current passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have enough passive income or you sell the property that produced the losses. So, the PAL rules can postpone any tax-saving benefit from rental property losses, sometimes for years.
Fortunately, there are several exceptions to the PAL rules that can allow you to deduct rental property losses sooner rather than later. Your tax professional can explain the exceptions and how they may affect you.
Excess Business Losses
The TCJA established an additional hurdle that you must clear to currently deduct rental property losses: For tax years beginning in 2018 through 2025, you generally can't deduct an excess business loss in the current year.
An excess business loss is one that exceeds $250,000 ($500,000 for a married couple who files a joint tax return). Any excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards. This loss disallowance rule applies after applying the PAL rules. So, if the PAL rules disallow your rental losses, this rule is a nonfactor.
Important: The CARES Act — a COVID-relief law that passed in 2020 — suspended the excess business loss disallowance rule for losses that arose in tax years beginning in 2018 through 2020.
If you manage to clear both of the preceding hurdles for your rental property losses, you can generally use those losses currently to offset taxable income from other sources. If losses for the year exceed income from other sources, you may have an NOL for the year. Thanks to an unfavorable TCJA change, you can generally carry NOLs forward to future years, but you can't carry them back to recover taxes you paid in earlier years.
The CARES Act allowed a temporary five-year carryback privilege for NOLs that arose in tax years beginning in 2018 through 2020. So, you can carry an NOL from one of those years back to an earlier year, deduct it and recover some or all of the federal income tax paid for the carryback year. Because federal income tax rates were generally higher in years before the TCJA took effect in 2018, NOLs carried back to pre-TCJA years can be especially beneficial.
If you have tenants that are hurting amid the COVID-19 pandemic, you're likely to have rental property tax losses. And with expenses rising due to surging inflation, losses are even more likely. Depending on whether you can successfully negotiate the PAL rules and the excess business loss rule, you may or may not be able to currently deduct the losses.
While Congress provided COVID-19 tax relief for losses sustained in 2018 through 2020, so far, those relief measures haven't yet been extended for tax years starting in 2021 or 2022. Contact us to discuss the optimal tax planning strategy for your situation or for an update on potential tax relief measures.
What If My Rental Property Generates Taxable Income?
Eventually your rental property should start throwing off positive taxable income again, instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you can now use them to offset your passive profits.
As a bonus, positive taxable income from rental real estate isn't hit with the dreaded self-employment tax, which applies to most other unincorporated profit-making ventures. This tax rate can be up to 15.3%.
But there's also a downside to consider: Positive passive income from rental real estate owned by a higher-income individual can get hit with the 3.8% net investment income tax (NIIT), and gains from selling properties can also get hit with the NIIT.
Back to the plus side, you also may be able to claim a personal deduction based on qualified business income (QBI) from your property. The deduction can be up to 20% of QBI, subject to restrictions that kick in at higher income levels. Specifically, for 2018 through 2025, the Tax Cuts and Jobs Act (TCJA) established a personal deduction based on QBI passed through to your personal tax return from a pass-through business entity. This refers to income from sole proprietorships, limited liability companies (LLCs) treated as sole proprietorships for tax purposes, partnerships, LLCs treated as partnerships for tax purposes and S corporations.
When the TCJA was signed into law, it was unclear if you could claim QBI deductions based on net rental income passed through to you from a pass-through entity. The IRS eventually issued taxpayer-friendly guidance that allows QBI deductions in most such cases, but you must follow complicated rules to collect the tax-saving benefit.