Rental Real Estate Tax Deductions
That rental real estate deduction might not be as clear cut as it seems
Many investors hear about the potential tax deduction they can get from owning rental property and they promptly begin looking for real estate to buy. If this sounds like you, take a deep breath first. It can pay to step back and evaluate your real estate pursuit in terms of its investment qualities.
Reality vs. Theory
In theory, the right type of rental real estate can be a good investment, particularly when you account for the ability it affords to use the associated tax deductions. And, of course, the key advantage is that you get to use someone else’s money to pay off the property and accumulate an asset.
But reality doesn’t always mirror theory. For example, let's assume that you want to purchase a fourplex. You gather all the pertinent information, things like purchase price, down payment, financing terms, repair money you'd have to put into it upfront, real estate taxes, estimated annual maintenance costs, and expected rents. Then you add in an expected vacancy rate and additional expenses that might crop up.
Contrast all this with any potential tax deductions the property would provide you. Run the numbers through a spreadsheet so you can see the effect of any rental real estate tax deductions you might be able to use. The spreadsheet should include your tax bracket and your ability to use any net rental losses to offset other income.
Rental Real Estate Tax Deduction Basics
When you own rental real estate, you can depreciate the asset, and this creates a loss from a tax perspective more often than not, even when your rental income covers all expenses. This loss is often referred to as the rental real estate tax deduction. Whether you can actually use it depends on how much other income you have.
If you have too little taxable income, the loss doesn’t benefit you much. And if you have too much taxable income—$150,000 or more if you're single as of 2017—you're not allowed to use the loss. Restrictions apply as to how much of a loss you can claim if your modified adjusted gross income falls between $100,000 and $150,000. These numbers apply to single and head of household taxpayers, as well as those who are married and filing jointly. Cut them in half if you're married and filing a separate return.
If you fall somewhere in between these parameters, the tax deduction created by owning a piece of rental property can be advantageous.
Now let's say that it takes you longer than expected to get the property into rental-ready shape. Additionally, it turns out that the rents you can actually charge are less than what your agent told you they would be. You might have accounted for some of this with the vacancy rate you calculated, but you're probably feeling like maybe buying the property wasn't such a smart move after all.
But the tax deduction you created saved you from $4,000 to $5,000 in taxes. That’s real money that would have been paid to the IRS in the current year so it may balance out.
How the Tax Deduction Affects Other Planning Decisions
What you decide to do financially in one part of your life, like buying investment property, can affect what you do in other parts of your life, such as investing in a 401(k) or Roth IRA. If you realize $4,000 to $5,000 in tax savings, and all other things being equal, should you increase your 401(k) contributions?
Not necessarily. Because of the rental loss and your other deductions, your effective tax rate might be running at about 15 percent. It might not make sense to put deductible money into your 401(k) plan to save just 15 percent, then possibly pay a higher tax rate 10 years down the road when you withdraw the money. A Roth IRA contribution would make more sense in this situation.
Make sure you take the time to learn and understand all the rules and ramifications of your tax situation, and speak with a qualified financial advisor before you go out and scoop up that rental property.