This article explores the topic of taxes and its impact on your rate of return. It examines the issue in greater depth than our recent post outlining ten things real estate investors should know. We provide readers with reliable information, but it is a complex area. An expert such as a CPA or tax attorney should be consulted for an in-depth analysis.
When people think of real estate, usually property taxes come to mind. However, for real estate investors, this is a cost of doing business, and factors into the rent charged to tenants. We are referring to income taxes.
We will look at the impact of taxes on rental property income. We are not examining capital gains or losses, which are applicable the year the property is sold.
If you do not “materially participate” in the business activities, it will fall under the passive activity classification. Real estate rentals are passive activities, even if you materially participate. According to the IRS, losses from passive activities that exceed income from passive activities are disallowed in that year, but it can be carried forward.
A numerical example might help to illustrate how works in practice. Assume you generate rental income of $100,000, and operating expenses (e.g. maintenance, management fees, utilities, insurance), and mortgage interest total $90,000. This gives an income of $10,000, but you can then deduct depreciation expense. You are allowed to depreciate the cost of residential buildings (but not the land) over 27.5 years, while commercial buildings are required to be depreciated over a 39 year period. If this totals more than $10,000, you have a loss. However, since this is a passive activity, you can use it to offset passive income elsewhere or carry the loss forward. At the worst, you will not owe any taxes due to the non-cash write-down of depreciation.
If you qualify as a real estate professional, rental activities would not be passive if you materially participate. However, that is beyond the scope of this article. There are also rules for active participation. We will assume real estate is not your full-time occupation, but a way to provide a boost to your income.
Similarly, in New York State, there are limits on passive activity losses. If your income-producing property is worth more than $40,000, you will be required to fill out a Real Property Income and Expense (RPIE) statement annually.