RENTAL REAL ESTATE AS AN INVESTMENT

• Posted on July 8, 2008
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A popular form of long-term investment is real estate rentals.  Rentals can fall into several varieties, of which real estate rentals is the most common.  This material will explain some of the tax ramifications of renting real estate, both residential and commercial.  Specifically excluded from this discussion are transient rentals, where the tenants rent for an average of seven days or less, such as motels and equipment (machinery) rentals.  Both are considered self-employment businesses for tax purposes and thus subject to self-employment taxes. 

One of the biggest benefits of owning rental property is that the tenants, over time, buy the property for you.  In addition, if structured properly, the allowable depreciation deduction will shelter the rental income. Another historical benefit of real estate rentals is capital appreciation.  Before acquiring a rental property, there are a number of things to consider, which include the following:

• After-tax cash flow,
• Potential for long- or short-term appreciation,
• Property condition (with an eye on when you might get stuck with a large repair bill),
• Debt reduction,
• Type of tenants,
• Potential for rent increases or re-zoning, and
• Whether there is community rent control, etc.  

Although most of the considerations are subjective, the after-tax cash flow can be estimated fairly easily.

For tax purposes, you will figure your profit or loss each year from operating the rental property.  Generally, you can virtually deduct all expenses incurred to operate the rental.  Browse through our list of potential operating expenses that are deductible. In addition, you will need to keep track of repairs and improvements and know how to distinguish between the two.

Rental real estate income is business income but is not subject to Social Security taxes. Real estate rentals are also considered passive activities. Generally, passive activity losses are only deductible to the extent of passive activity income.  However, there are two exceptions to that rule: (1) where there is active participation, and (2) real estate professional exception.  Any losses not allowed under these two exceptions are not lost but suspended, and carried forward indefinitely to tax years in which your passive activities generate enough income to absorb the losses. To the extent your passive losses from an activity aren`t used up in this fashion, you will be allowed to use those losses in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.