What Your Accountant Wants You to Know When You Buy Rental Property
There are a number of considerations that your accountant wants you to be aware of when you purchase a rental property. These include whether to form a legal entity to hold the property, and if so- what type of entity, maintaining separate books and records, whether expenditures are tax-deductible when paid or are required to be capitalized and depreciated for deduction later, and whether you might qualify for tax-favorable status as a real estate professional, and a number of other topics.
Separate Legal Entity
Although use of an entity is not required, it generally is advisable to do so because under many circumstances it protects other assets you own from potential claims originating from the rental property. C-corporations, S-corporations, partnerships, and limited liability companies (LLCs) are common options. Most lawyers will recommend use of LLCs due to their combination of flexibility and legal protection. Whether you form a separate legal entity to hold the property or take title personally, it is important to keep the activity of the rental property separate from your personal financial activity.
Separate Bank Account and Bookkeeping
The first step in treating your rental property as separate from your personal activities is opening a bank account just for the property. Very closely related to opening a separate bank account is maintenance of a separate set of books and records for the rental activity. Isolating the receipts and disbursements related to the rental activity from your other personal financial activity will make it much easier to compile information for tax returns at year end or assemble records necessary to obtain a loan.
Using basic accounting software, such as QuickBooks, is a great way for you to track your rental income and expenses and summarize that financial activity. Although it is certainly possible to use spreadsheet software like Excel, or even just pencil and paper to track your rental activity, accounting software that is specifically designed for this purpose will prove to be well worth the purchase price and the investment of time to learn it.
Cash vs Accrual Accounting Method
Before you file your first tax return or assemble records for a lender, you will need to decide if you want to report your rental activity under the cash (cash receipts and disbursements) method of accounting or the accrual method of accounting. What’s the difference? Under the cash method, you generally report income when you receive cash, and you report expenses when you pay cash. Under the accrual method, you report income when you earn it (regardless of when you collect it) and you report an expense when you incur it (instead of when you pay it). Most small businesses find the cash method preferable, primarily for its simplicity. Using the cash receipts and disbursements method also avoids the possibility of paying tax on income that hasn’t yet been received. Many lenders, though, prefer use of the accrual method. Your accountant can help you evaluate which method is right for you.
Mixed Use Property
What if your rental property is a multi-family property and you live in part of the property? In this case, for tax purposes you need to separately treat part of the property as a business and part of the property as your personal residence. Let’s assume that you have a two family building and you live in one side and rent out the other. Rental income is related to the rental portion of the property but what about expenses such as repairs and property taxes? Here we can break expenses into two basic categories - direct and indirect.
Direct expenses are those that are completely attributable to either the rental portion of the property or to the personal part. For example, assume you pay a plumber $300 to repair a toilet. If the toilet is in the rental unit, then it is 100% deductible. If it is in the personal residence, then it is a nondeductible personal expense.
Many expenses aren’t that clear cut, of course. Mortgage interest, real estate taxes, painting the outside of the entire building, or plowing a shared driveway are all expenses that need to be split between the rental portion and the personal portion. Generally speaking, the IRS will allow any method that is fair and reasonable. Examples of possible methods include allocation based on the number of units or square footage. There is some leeway here but the methodology employed should be reasonable and justifiable based on your facts and circumstances.
Note that mixed-use property presents some complexities – beyond the scope of this article – that surface when such property is sold.
Expenditures for Property Repairs and Improvements
Not all outlays are tax-deductible when incurred. The IRS requires that certain expenditures are capitalized and depreciated over predetermined recovery periods, which could range from 3 to 39 years. Generally Internal Revenue Code 263(a) requires the costs of acquiring, producing, and improving tangible property to be capitalized with no regard to the size of the project or cost incurred. In 2013 the IRS issued tangible property regulations which provide much of the current guidance. These rules are incredibly complex, and what follows is a brief overview of some rules that impact rental property.
There are three exceptions that a taxpayer may be able to utilize to allow immediate deductions in lieu of capitalizing the purchase cost: (1) the de minimis safe harbor; (2) the small taxpayer safe harbor; and (3) the routine maintenance safe harbor.
- De Minimis Safe Harbor: This is available to all taxpayers and allows the immediate expensing of any purchase of tangible property that cost under $2,500 per invoice or item.
- Small Taxpayer Safe Harbor: This exception is available to taxpayers with three year average gross receipts under $10m if the unadjusted cost basis of the building is less than $1m. If the taxpayer meets these thresholds and the amounts paid for repairs, maintenance, or improvements does not exceed the lower of 2% of the unadjusted cost basis of the building or $10,000, the expenses may be deducted in the year incurred.
- Routine Maintenance Safe Harbor: This is available to all taxpayers and allows the immediate expensing of select regular maintenance expenses that can reasonably be expected to occur more than once during the useful life of an asset. Building improvements expenditures include costs that one can reasonably expect to occur more than once during a 10 year period. Examples include costs such as painting or carpets. Note that this exception does not apply to betterments (e.g., physical enlargements, expansions, extensions, or additions), adaptations (e.g., material change in property use), or restorations (e.g. returning property to its intended use after being in disrepair).
If a cost cannot be expensed under one of the exceptions discussed above, further analysis must be performed. Buildings are broken down into specific “units” of the property, including plumbing, electrical, building structure, and others. A taxpayer first must determine what unit of the building the new expenditure applies to, then determine if the expenditure is an improvement (betterment, restoration, or adaptation to a new use) to that particular unit of property. This determination is based on the facts and circumstances of the expenditure and the scope of the work performed relative to the related “unit” of property.
Limitations on Deduction of Losses
An often discussed benefit of investing in real estate is the potential tax losses that are created and passed through to an owner’s personal tax return. However, losses from typical real estate rental activities are classified as “passive” by Treasury Regulation 1.469-1T(e)(1), and Internal Revenue Code Section 469 states that generally losses from passive activities cannot be used to reduce other income. In other words, rental losses cannot offset income from wages or investments. Instead, disallowed rental losses are “suspended” and carried forward, and can be claimed once rental income is produced, or the property is disposed of.
The small landlord exception allows taxpayers to claim rental losses of up to $25,000 against other sources of income if the taxpayer’s modified adjusted gross income is under $100,000. The $25,000 loss allowance phases out as modified adjusted gross income rises from $100,000 to $150,000.
Qualified Real Estate Professional
An exception to the passive loss restrictions described above is provided to “qualified real estate professionals.” Taxpayers qualify as real estate professionals (and may therefore use rental losses to offset unrelated income) if greater than 50% of their personal services are involved in real property trades or businesses, and they perform over 750 hours of services during the year in real property trades or businesses. When a taxpayer has interests in multiple real property trades or businesses, an election may be used to aggregate all rental real estate interests as a single activity for the purposes of meeting the two tests noted previously. Taxpayers should maintain a record of hours worked in each activity to provide proof that the qualifications of this favorable status have been met.
There are a number of tax and accounting considerations involved with owning rental property, and hopefully the topics discussed in this article gave you a good taste for some of the more common issues. However, there are many other considerations that could be relevant to your particular situation, including short term rentals, tax basis issues such as cost segregation analysis, planning for the disposal of the property and related tax deferral strategies, and state and local tax planning. Be sure to work with your accountant to ensure you are familiar with, and taking advantage of the rules.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.