TAXING TIMES, SEPTEMBER 2014 EDITION
By Rick Torkelson, CPA and principal of Torkelson & Associates, LLP in Petaluma, CA
As the equity builds up on our homes and it gets easier to borrow money and with interest rates remaining pretty low, I’m often asked “What effect would it have on my tax return if I bought a house and rented it out?”
A rental house is a small business – All the rent you receive is taxable income and all the expenses to generate that income is deductible. Deductions include interest on any loans to purchase the rental, property taxes, insurance, repairs, management fees, anything you spend to own that house – plus Depreciation.
Depreciation is the ability to deduct the cost of the house – slowly – over 27 ½ years if we’re depreciating residential property, 39 years if you’re depreciating commercial property.
An example is probably the best way to understand. Suppose we buy a house for $400,000. We put $100,000 down and finance $300,000 for thirty years. Our interest and principal payment is about $1,600 per month. Let’s say our property taxes and insurance total another $500 per month and our repairs and everything else is another $400 per month. We’ll charge $2,500 per month to rent this house – do the math and our cash is breaking even – $2,500 coming in each month, $2,500 going out each month – not a bad deal in Sonoma County. Before depreciation, this situation would actually show about $4,500 in income for the first full year – this is because that monthly mortgage payment would pay about $4,500 in principal in the first full year which is not deductible. Depreciation for the first year would be about $11,000 – computed by dividing the cost of the rental (not the land) by 27½ years. Add it all up and you have no cash out of your pocket (not counting the $100,000 we put down) and we show a loss on our tax return of $6,500. Assuming we are in a State and Federal tax bracket of 34.3%, this would save $2,230 in income taxes – if we can deduct this “passive” loss.
Rental losses are “Passive”. Back in 1986, the tax law developed this concept of passive loss which simply stated says “You can’t deduct a passive loss unless you have passive income”. Most taxpayers have no passive income – we must actively earn all the income we get. But Congress wasn’t completely unsympathetic to the average taxpayer – the tax law lets you deduct up to $25,000 in losses from passive activity – as long as your gross income is $100K or less. If your gross income exceeds $100K this 25K in allowable passive loss phases out until you earn $150K at which time you cannot deduct any passive loss without passive income. Back in 1986, only a small percentage of taxpayers earned over 150K, but now, it is common for rental owners to earn this much – thus wiping out the ability to deduct losses. One good thing (or actually non-bad thing) about passive losses is that if you can’t deduct the loss, they save up until you can deduct them. For most taxpayers, this means you save up the passive losses until you sell the rental at which time any undeducted passive losses are fully deductible.
Next month I’ll write about the tax effects of disposing the rental.
If you pay estimated taxes, your 2014 Estimate #3 is due 9/15/14. A word about estimates – If you think you might owe tax on April 15th, but you don’t know how much, you might consider paying an estimate. No one knows for sure how much estimate you should pay until after you file your return. Underpayment penalties are the gentlest of all IRS penalties – For the last 3 years, only 3% annual rate. If after filing your 2014 return you should have paid a $1,000 on 9/15/14, you would have a penalty of 3% of $1,000 for 7 months – about $17.50. If you forget to pay your estimate on 9/15/14, pay it whenever you can – your penalty will be computed on the days between 9/15/14 and when the IRS receives it – a week late on that same $1,000 estimate – Your penalty would be less than a dollar.