We get a lot of questions about rental real estate properties and income taxes. In this article, we will cover the major topics the commonly come up:
Do I Need an LLC?
The first, most common question, we get is whether you need an LLC or not. If you are just considering income tax purposes, then it doesn’t matter whether the property is held in your personal name or a company name. You get the exact same write-offs for expenses and depreciation either way (and the same passive activity limits).
The major advantage of owning the property through an LLC is liability protection. For the sake of argument, let’s say someone walking on the sidewalk in front of your property trips and falls, breaking a bone. Clumsy Man decides to sue the owner of the property for not maintaining the sidewalk properly.
If the property is owned by an LLC, Clumsy Man can only go after the assets held by the LLC (in most cases, your situation is unique, we are not your attorneys not offering legal advice, etc). If the property is owned by you personally, then Clumsy Man can attempt to go after everything you own. While this can be mitigated by good insurance policies, operating in the LLC limits your liability. Hence the name, limited liability company.
What About Getting a Mortgage?
The vast majority of mortgages require a personal guarantee in order to issue the mortgage. If you buy the property in an LLC, many lenders will either require a much larger downpayment (30 – 50%) or will not lend on the property at all.
Shopping around with different lenders and working with a good mortgage broker is key to getting these kinds of deals done.
One strategy some people employ is to buy the property in their personal name, and then contribute the property to a new LLC to limit liability. There are a couple technical issues with this, but those can be dealt with. The largest risk to using this strategy is the Due on Sale clause.
This clause, which is in almost every mortgage originated since 1982, says the lender has the right to call the loan due upon any kind of sale. So when the individual owner contributes the property to the LLC, that is a sale as it changes the ownership. The lender has the right, if they choose, to call the loan due and demand immediate payment for the entire balance. They typically do not enforce the due on sale clause as long as the payments are kept current, but they certainly can if they want to.
Do I Need to File in Every State?
If your rental property is in a different state than your personal residence, then yes, you have to file an income tax return for each state where you earn have income.
If you live in Florida, but have rental property held by you in North Carolina, then you will need to file a North Carolina income tax return that details the activity occurring in North Carolina.
If the property is held by an LLC residing in North Carolina then both the LLC and the owner of the LLC would need to file a North Carolina return in addition to their Federal returns.
Tax Benefits of Rental Real Estate
Unlike your personal residence where you live, the expenses related to a rental property are fully deductible, up to certain limits.
Typical deductions include advertising, travel costs, cleaning and maintenance, commissions, insurance, legal expenses (e.g. for evictions or drawing up leases), management fees, mortgage interest (limits may apply), repairs (may be subject to capitalization limits), supplies, property taxes, homeowners association dues, security system fees, and other expenses that are directly related to the property that are needed to generate renal income.
Depreciation allows the owner to write off a portion of the building over time. The rules and timelines for how long the assets are to be depreciated have changed a bit due to the Tax Cut and Jobs Act (a.k.a. TCJA or Trump tax reform), but in general about 3.5% of the building is written off against the rental income each year.
Section 199A Deduction
Section 199A, or the qualified business income (QBI) deduction, is a new provision under TCJA. It provides a tax break on pass-through taxable income, up to 20%. Rental real estate does qualify for the 199A deduction in most cases. So if you have taxable income of $50,000, and your net income from rental real estate is $10,000 of that $50,000, then you will get a deduction of up to $2,000 – 20% of the $10,000. So that $2,000 portion is tax-free.
Like all things with the IRS, formulas and thresholds apply.
Passive Loss Limitations
Many times, rental real estate operates at a loss on a tax basis. That can be due to a tenant refusing to pay and causing an eviction, an expensive upgrade, or just the depreciation on the property creating a large deduction compared to the amount of income.
The IRS limits how much of a loss can be taken by a passive real estate investor of $25,000. In this context, passive means less than 750 hours a year (roughly 15 hours a week) or an owner that is not a real estate professional (agent, broker, etc).
The loss gets phased out from $100,000 to $150,000 for joint
Assuming the property is held more than a year, the profits of the sale will be subject to long-term capital gains, which can vary from a tax rate of 0% to 24% (including additional Medicare tax) depending on other factors in your tax return.
The capital gain is determined by the sale price – purchase price – closing costs – current year carrying costs + depreciation. So it is important to note that depreciation taken as a deduction in past years is added back to the total gain when sold.
It is also important to notice that how much of a mortgage is owed is not factored into the capital gain.
Additionally, capital gains are not included in Section 199A deductions.
Every Situation is Unique
Like everything in the world of income taxes, your situation is unique and we will discuss how to structure your real estate for the maximum advantage.