To start, ask yourself these two questions about owning a rental:
- Are you thinking about going from living in your own house as an owner to a landlord and a renter?
- Is your current house value above, at, or close to 280k?
How Does Owning a Rental Affect Your Taxes?
If you answered yes to these two questions and depending on your family status you could geta very interesting surprise on next year’s taxes.
Background:For home ownership versus renting to make sense you haveto itemize. The standard deduction for singles is $6,200 and married is $12,400. Therefore you have to exceed your ability to itemize. While per the IRS there are13 ways onecan deduct under itemization.
In order for you homeownership to matter you have to itemize versus taking the standard deduction. Per IRS guidelines you can deduct one’smortgage interestandreal estate taxas part of the 13 ways. These, for most people, are the largest “tie breakers” although some charitable donations could also be the reason to itemize. For many, charitable donations are just “extra” but the mortgage interest is the thing that really makes sense.
That is why it is important to understand the “cost” of your home. Our “cheap” houses didn’t have enough interest to make sense to itemize as we didn’t donate large amounts.
So if you have a “large” mortgage you could feel a “large” affect when you rent that house out and rent a property for yourself instead of buying again.
Here’s Why!
For military members BAH is tax free and depends on your area. In high cost areas you receive more BAH, in low cost areas you receive less. Makes sense. If you live in a high cost area and use your tax free BAH towards a mortgage instead of rent (with all variables staying the same, maintenance etc.) Then buying (not including appreciation, etc.) will affect you taxes greatly in a positive way.
For example:An O3 with dependents makes $2,610 in BAH in one location.
For the sake of the example assume Interest rate is 3.85, VA loan (no down payment or PMI), property tax 1.3%, insurance .3%.
You could buy approximately a 425k home and your payment is $2560 a month.
- Mortgage Interest- 16,227/first year
- Property Tax – 5,525/per year
- Total- $21,752
Saying you have no more expenses then the rental, you are able to write off $21,752 off your taxes plus whatever other deductions make sense.
Now, let’s assume you rent this house out. As a rental you have moved from a schedule A to schedule E. While we discuss the “rental equation” and it is noticeable that one is able to “shield” a lot of profit we didn’t discuss theadded incomeeffect.
Let’s continue with the above example. Let’s assume one is married so he get the standard 12,400 deduction. So now we take $21,752 (mortgage interest + property tax)- standard deduction = 9,352.Let’s assume you are at the 25% tax rate. So this “savings” is worth $2,338 in tax savings!
Another Note
This is a tax “deduction” so it come off how much you earn and your “category”. So if it brings you below a large tax threshold or allows you to be able to partake in credits that you otherwise wouldn’t be eligible for it would have a lot more affect than the belowillustrates.
Let’s Continue
So now you decide to rent this home out and you rent at the next duty station. You lose this $2,338 in tax savings or $21,752 “deduction”. Lets assume that your house rents for $2,700 a month.Now you have anincomeof $32,400. While you can usually show a “book” loss or close to one your taxes are still going to be affected because the government provides no “credit” for being a renter while you can deduct much of your mortgage payment.
The big “elephant” in the room is the fact we accounted for no maintenance. Things break in houses, so the reality of putting no money in to the house is usually unrealistic. This is especially true depending on the age of the home and the length of time you maintain it. That being said this is still important to take in to account.
Surprises at tax time are NOT fun!
As always this is food for thought. I HIGHLY recommend you get an accountant. A CPA is a professional you want on your side. They understand all of the tax code nuances and are up to date on all of the changes made to the code every year. This article is just to help one understand that their house purchase might be helping them more than they think!
What is your experience? Has owning a rental affected your taxes?
FAQs
Usually rental properties will generate positive cash flow while creating a tax loss due to the depreciation of the property. After about 10-15 years, the depreciation will be lower and the property should create positive taxable income.
What is a major disadvantage of owning rental property? ›
The drawbacks of having rental properties include a lack of liquidity, the cost of upkeep, and the potential for difficult tenants and for the neighborhood's appeal to decline.
How does rental income affect your taxes? ›
You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. Expenses of renting property can be deducted from your gross rental income. You generally deduct your rental expenses in the year you pay them.
How does owning an investment property affect taxes? ›
Main tax benefits of owning rental property include deducting operating and owner expenses, depreciation, capital gains tax deferral, and avoiding FICA tax. In most cases, income from a rental property is treated as ordinary income and taxed based on an investor's federal income tax bracket.
How does IRS catch unreported rental income? ›
Ways the IRS can find out about rental income include routing tax audits, real estate paperwork and public records, and information from a whistleblower. Investors who don't report rental income may be subject to accuracy-related penalties, civil fraud penalties, and possible criminal charges.
What are 3 drawbacks to owning rental real estate? ›
Cons: 5 risks of owning rental property (and how to mitigate them)
- Your home is at the mercy of the tenants placed in it. ...
- Tenants can fall behind in their rent payments. ...
- Managing a rental property is hard work. ...
- Rental home owners can face unexpected costs. ...
- A rental home is a large concentration of assets.
An extended vacancy is undoubtedly one of the biggest financial risks involved in investing in rental homes since it's essentially lost money. If you can't consistently rent your space, you're still responsible for paying the property's expenses — without generating income to offset the cost.
What happens if my expenses are more than my rental income? ›
If your rental expenses exceed rental income your loss may be limited. The amount of loss you can deduct may be limited by the passive activity loss rules and the at-risk rules. See Form 8582, Passive Activity Loss Limitations, and Form 6198, At-Risk Limitations, to determine if your loss is limited.
What does the IRS consider rental income? ›
Cash or the fair market value of property or services you receive for the use of real estate or personal property is taxable to you as rental income. In general, you can deduct expenses of renting property from your rental income.
Can I deduct a mortgage payment from rental income? ›
As a rental property owner, you can claim deductions to offset rental income and lower taxes. Broadly, you can deduct qualified rental expenses (e.g., mortgage interest, property taxes, interest, and utilities), operating expenses, and repair costs.
Here are additional deductions real estate investors with rentals may be able to take as well:
- Repairs and Maintenance.
- Insurance.
- Property Management Fees.
- Supplies.
- Utilities (Oil, Gas, Electric, Water, Phone, etc.)
- Home Office Expenses.
- Travel Expenses.
- Snow Removal, Landscaping, Pest Control, etc.
Generally, a good ROI for rental property is considered to be around 8 to 12% or higher. However, many investors aim for even higher returns. It's important to remember that ROI isn't the only factor to consider while evaluating the profitability of a rental property investment.
Does rental income count as earned income? ›
Rental income is typically considered to be unearned income by the IRS. Unlike earned income, which primarily includes wages, salaries, or business income from active participation, unearned income typically includes sources such as interest, dividends, and rental income from real estate.
How does the IRS know if you have a rental? ›
IRS agents can check real estate paperwork and public records to verify the information reported on your return. Some states require rental property owners to have licenses.
Does the IRS audit landlords? ›
Owning and managing rental properties comes with several advantagous tax rules. However, they can be complex and often trigger IRS audits. Owning and managing rental properties allows you to take advantage of a number of highly beneficial tax laws.
Can you deduct rental expenses with no rental income? ›
No. If your income property was vacant (or rented for a limited time) and spent the rest of the year vacant, you cannot deduct the vacancy as a loss of income. Typically, you are able to deduct the necessary expenses to maintain the property, including depreciation.
What is a major disadvantage of owning rental property on Quizlet? ›
What is a major disadvantage of owning rental property? Risk of the tenant not making all of his or her rent payments.
Is it worth keeping a rental property? ›
Yes, owning rental property is worth it. The real estate value has increased drastically over the past years. It's worth the hassle if you want to generate long-term wealth during or before retirement.
What are the pros and cons of having a rental property? ›
People invest in rental property for a number of reasons, such as to diversify an investment portfolio, generate rental income, and have more direct control over their investments. Potential drawbacks to owning a rental property include lack of liquidity, dealing with tenants, and deteriorating neighborhoods.
What are the disadvantages of depreciating a rental property? ›
The biggest con of depreciating comes down to what happens after selling a rental property: If you have claimed an annual depreciation expense before, you'll be liable to pay a depreciation recapture following the rental property's sale.
