To start, ask yourself these two questions about owning a rental:
- Are you thinking about going from living in your own house as an owner to a landlord and a renter?
- Is your current house value above, at, or close to 280k?
How Does Owning a Rental Affect Your Taxes?
If you answered yes to these two questions and depending on your family status you could geta very interesting surprise on next year’s taxes.
Background:For home ownership versus renting to make sense you haveto itemize. The standard deduction for singles is $6,200 and married is $12,400. Therefore you have to exceed your ability to itemize. While per the IRS there are13 ways onecan deduct under itemization.
In order for you homeownership to matter you have to itemize versus taking the standard deduction. Per IRS guidelines you can deduct one’smortgage interestandreal estate taxas part of the 13 ways. These, for most people, are the largest “tie breakers” although some charitable donations could also be the reason to itemize. For many, charitable donations are just “extra” but the mortgage interest is the thing that really makes sense.
That is why it is important to understand the “cost” of your home. Our “cheap” houses didn’t have enough interest to make sense to itemize as we didn’t donate large amounts.
So if you have a “large” mortgage you could feel a “large” affect when you rent that house out and rent a property for yourself instead of buying again.
Here’s Why!
For military members BAH is tax free and depends on your area. In high cost areas you receive more BAH, in low cost areas you receive less. Makes sense. If you live in a high cost area and use your tax free BAH towards a mortgage instead of rent (with all variables staying the same, maintenance etc.) Then buying (not including appreciation, etc.) will affect you taxes greatly in a positive way.
For example:An O3 with dependents makes $2,610 in BAH in one location.
For the sake of the example assume Interest rate is 3.85, VA loan (no down payment or PMI), property tax 1.3%, insurance .3%.
You could buy approximately a 425k home and your payment is $2560 a month.
- Mortgage Interest- 16,227/first year
- Property Tax – 5,525/per year
- Total- $21,752
Saying you have no more expenses then the rental, you are able to write off $21,752 off your taxes plus whatever other deductions make sense.
Now, let’s assume you rent this house out. As a rental you have moved from a schedule A to schedule E. While we discuss the “rental equation” and it is noticeable that one is able to “shield” a lot of profit we didn’t discuss theadded incomeeffect.
Let’s continue with the above example. Let’s assume one is married so he get the standard 12,400 deduction. So now we take $21,752 (mortgage interest + property tax)- standard deduction = 9,352.Let’s assume you are at the 25% tax rate. So this “savings” is worth $2,338 in tax savings!
Another Note
This is a tax “deduction” so it come off how much you earn and your “category”. So if it brings you below a large tax threshold or allows you to be able to partake in credits that you otherwise wouldn’t be eligible for it would have a lot more affect than the belowillustrates.
Let’s Continue
So now you decide to rent this home out and you rent at the next duty station. You lose this $2,338 in tax savings or $21,752 “deduction”. Lets assume that your house rents for $2,700 a month.Now you have anincomeof $32,400. While you can usually show a “book” loss or close to one your taxes are still going to be affected because the government provides no “credit” for being a renter while you can deduct much of your mortgage payment.
The big “elephant” in the room is the fact we accounted for no maintenance. Things break in houses, so the reality of putting no money in to the house is usually unrealistic. This is especially true depending on the age of the home and the length of time you maintain it. That being said this is still important to take in to account.
Surprises at tax time are NOT fun!
As always this is food for thought. I HIGHLY recommend you get an accountant. A CPA is a professional you want on your side. They understand all of the tax code nuances and are up to date on all of the changes made to the code every year. This article is just to help one understand that their house purchase might be helping them more than they think!
What is your experience? Has owning a rental affected your taxes?
FAQs
You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. Expenses of renting property can be deducted from your gross rental income. You generally deduct your rental expenses in the year you pay them.
How does owning an investment property affect taxes? ›
As a rental property owner, you can claim deductions to offset rental income and lower taxes. Broadly, you can deduct qualified rental expenses (e.g., mortgage interest, property taxes, interest, and utilities), operating expenses, and repair costs.
What is a major disadvantage of owning rental property? ›
The drawbacks of having rental properties include a lack of liquidity, the cost of upkeep, and the potential for difficult tenants and for the neighborhood's appeal to decline.
How is rental income taxed the advantages of being an owner? ›
Main tax benefits of owning rental property include deducting operating and owner expenses, depreciation, capital gains tax deferral, and avoiding FICA tax. In most cases, income from a rental property is treated as ordinary income and taxed based on an investor's federal income tax bracket.
Does IRS know your rental income? ›
Ways the IRS can find out about rental income include routing tax audits, real estate paperwork and public records, and information from a whistleblower. Investors who don't report rental income may be subject to accuracy-related penalties, civil fraud penalties, and possible criminal charges.
Does rental income count as earned income? ›
Rental income is typically considered to be unearned income by the IRS. Unlike earned income, which primarily includes wages, salaries, or business income from active participation, unearned income typically includes sources such as interest, dividends, and rental income from real estate.
How do I maximize tax deductions on a rental property? ›
Here are additional deductions real estate investors with rentals may be able to take as well:
- Repairs and Maintenance.
- Insurance.
- Property Management Fees.
- Supplies.
- Utilities (Oil, Gas, Electric, Water, Phone, etc.)
- Home Office Expenses.
- Travel Expenses.
- Snow Removal, Landscaping, Pest Control, etc.
Rental Losses Are Passive Losses
This greatly limits your ability to deduct them because passive losses can only be used to offset passive income. They can't be deducted from income you earn from a job or investments such as stock or savings accounts.
What is not deductible as a rental expense? ›
If market rate rent is not received, then this lost income and associated time is not deductible against rental earnings. Expenses for improvements and upgrades to the property also generally cannot be deducted and instead must be capitalized. This includes things like: Adding or renovating rooms.
What is the biggest risk of owning a rental property? ›
An extended vacancy is undoubtedly one of the biggest financial risks involved in investing in rental homes since it's essentially lost money. If you can't consistently rent your space, you're still responsible for paying the property's expenses — without generating income to offset the cost.
Protection Against Inflation
Owning a rental property is a safe investment and an even better asset that can make money during periods of high inflation. It gains value when inflation is high and creates cash flow from renting during any economic period.
What are the 4 drawbacks of owning a small rental property? ›
Cons: 5 risks of owning rental property (and how to mitigate them)
- Your home is at the mercy of the tenants placed in it. ...
- Tenants can fall behind in their rent payments. ...
- Managing a rental property is hard work. ...
- Rental home owners can face unexpected costs. ...
- A rental home is a large concentration of assets.
Rental income you receive from real estate does not count for Social Security purposes unless: You receive rental income in the course of your trade or business as a real estate dealer (see §§1214-1215); Services are rendered primarily for the convenience of the occupant of the premises (see §1218); or.
Can you deduct rental expenses when you have no rental income? ›
No. If your income property was vacant (or rented for a limited time) and spent the rest of the year vacant, you cannot deduct the vacancy as a loss of income. Typically, you are able to deduct the necessary expenses to maintain the property, including depreciation.
Is rental income passive income? ›
The IRS considers a rental activity to be passive if real estate is used by tenants and rental income (or expected rental income) is received mainly for the use of the property. In other words, owning a rental property and collecting rental income is considered passive and not active in most cases.
What happens if I don't report rental income? ›
So you may face adjustments to your entire return, not just your income. At the very least, you'll owe back taxes. That's the remaining unpaid amount associated with your return. Besides back taxes, you may face fines, penalties, and criminal charges.
Does rental income loss affect taxes? ›
Rental real estate proceeds are considered to be passive income, like stock profits. The tax code considers rental losses to be passive losses. In general, fewer taxpayers qualify for such deductions. By definition, they are not earned income.
Can I deduct mortgage payments from rental income? ›
While the principal portion of a mortgage payment is not an expense (because you are simply paying down your loan balance), the remaining items, including mortgage interest, property taxes, and insurance, can typically be deducted against the income received from the properties.
How do you calculate rental income? ›
Gross yield on a rental property is the percentage of profit before expenses have been deducted. To calculate, first multiply the monthly rent amount by the number of months in the year to determine the income from rent; then, divide the income from rent by the appreciated home value.
