I’m thinking about renting out my personal residence when I move.
This article is meant to inform and educate. It is by no means exhaustive on this topic. This article should not be considered advice on your particular situation as every tax situation is different. It is always recommended that you consult a tax professional.
How do the taxes work on my rental?
Sometimes you just have to move and sometimes it is difficult to sell your house before you have to buy a new one. Many taxpayers decide to rent out their previous residence for a variety of reasons. Maybe you inherited a house and decide to turn it into a rental property.
This article is not going to tell you how to rent out your home but begin to explain some of the tax issues surrounding residential rental property.
Net income from rental of your house (or even just a room in your house) is taxable on your 1040 on the Schedule E. Start with the income from rents and then deduct expenses. Taxes, mortgage interest, insurance, repairs, and maintenance…
One amount you can not use as a write off is the mortgage payment. Now before you get upset about this, you will eventually end up writing it off, it just gets written off in pieces. Basically, the items paid through escrow are deducted—the insurance and taxes–in the year in which you paid them. The interest on the mortgage is deducted separately. These items show up on the 1098 mortgage interest statement you will get at the end of the year from the bank. What is not a direct deduction is the principal portion of the monthly mortgage payment. The principal is deducted through depreciation.
What is Depreciation and how does it effect me?
Let’s talk depreciation.
Business assets (and your rental house is considered a “business asset”) with a useful life of more than one year almost always are written off through depreciation. What this means is that the whole amount won’t be deductible all at one time, but over a certain period that is set by the IRS. Residential rental property is a 27.5-year asset. This means that for 28 years, you get to write off a part of the cost of the house.
When I said cost, the official word is really “basis.” First, land is not depreciable, so the land holds its value and is not part of the depreciation deduction. The depreciable basis is the cost of the house minus the land, plus significant improvements, and a few other things, minus a couple other items. If you need details or help calculating the depreciable basis of your house, call our office for a consult. 912-335-5404
According to the IRS the depreciation on your house is allowed or allowable. This means that whether or not you take a write-off for the depreciation, it still depreciates in value on paper. If you were to sell that rental house, your basis is no longer what it was when you started. This means an increased gain. That is because you already got the tax benefit of the cost of the house each year as a depreciation expense deduction.
What is the Difference between a Repair and an Improvement?
Other items you pay for in the course renting your house are also required to be depreciated and not simply expensed (written off all at one time). They are items like replacing the roof, replacing the windows, installing a new air conditioner, buying new appliances, repainting the house… Is it simply a repair, or is it a replacement? Or an improvement? The first clue to the depreciating versus expensing question is, will this item last more than one year? Next, how does the IRS require you to treat this asset? Does this action improve the property? Increase the value of the property? Again, if you need help making this determination, please contact our office. 912-335-5404
Paying Contractors
If you have people or businesses who do work for you on your rental property (such as landscaping, plumbing, bookkeeping…) and you pay them more than $600 in one year, you are required to issue those persons or businesses a 1099NEC by January 31 of the following year. (An exception to this rule would be if the business is incorporated. And you would not know the answer to this unless you ask.)
In order to provide a 1099NEC you will need to have the worker fill out a W9 which is a request for tax information. It requests the name of the person or business, their taxpayer ID number, and their address. All this information is required by the IRS to file the 1099NEC. If you do not file the 1099NEC, the IRS can and will deny the deduction. Preparing 1099’s of many types is one of the services we provide at First City Income Tax, should you need assistance.
Gains and Losses
Many clients experience a loss on rental property, especially if that property still has a mortgage. Most rental activity is considered by the IRS as a passive activity and there can be limits on the amount of loss a taxpayer can actually claim on the tax return. Those limits depend on the percentage of ownership, the AGI and filing status of the taxpayer, and the amount of the loss. It is possible that even though you experience a loss, you may not be able to recognize it in the current year due to limitations. In this case, the loss carries over until the taxpayer can recognize it. Some events that might trigger this can be lower income in a future year, or eventual sale of the rental property.
The sale of the rental property can also be tricky. This is due to the depreciation expense that has been taken. It is considered business property and subject to the rules of the sale of business property. Property that was previously your primary residence has its own set of rules. You may not be able to exclude the gain on the sale of your property even though it may pass the primary residence test.
It is always a good idea to get a professional opinion. Please call our office if you have questions. 912-335-5404.
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