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Article by: Jeff Skolnick, CPA, M.S. Taxation
Many people I speak to have questions regarding rental properties. Real estate has always been one of the most popular investment vehicles but with the myriad of rules surrounding rental real estate taxpayers are often confused by what they can and cannot do on their tax returns. This article offers a quick overview of the rules relating to rental real estate.
Since the Tax Cuts and Jobs Act passed when discussing real estate I and most other people have concentrated on the ability to take a 20% deduction against rental income, A nice deduction indeed, but what if you have a loss from rental real estate? What do the rules say then? This article will explain how taxpayers handle these losses.
Background
The government generally only allows losses from “passive activities” to offset income from “passive activities”. Passive activities are any trade or business in which the taxpayer does not materially participate. Real estate rental is generally considered a passive activity and therefore if the general rule was followed, losses would only be allowed against income from passive activities. There are, however, two major exceptions to the general rule.
The two exceptions are for: (1) real estate professionals and (2) up to$25,000 of losses, subject to an Adjusted Gross Income (AGI) phase-out.
Real estate professional
A qualifying real estate professional is allowed to deduct losses from a rental property without limit. The losses while without limit would still have to be legitimate and expenses are subject to the same IRS definition of ordinary and necessary as all other businesses.
A taxpayer qualifies as a real estate professional if:
Real property generally refers to real estate and real estate property trades or businesses include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.
Material participation is defined as:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (a somewhat lesser standard than material participation) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
$25,000 Allowance
Taxpayers qualifying for this treatment are allowed to deduct up to $25,000 of rental real estate losses against their ordinary income. In order to be eligible for this deduction the taxpayer must:
Actively participate in the rental activity. This means the taxpayer and/or spouse must own at least 10% of the rental property and must have substantial involvement in the management of the property. Active participation includes making management decisions and arranging for others to provide services. Examples of these decisions would include approving new tenants, deciding on rental terms and approving capital improvements or repair expenditures. Taxpayers may qualify as active participants even if utilizing a management company.
Taxpayers meeting the above criteria, as stated earlier, may deduct losses from rental activities up to $25,000 subject to an income phase-out. When a taxpayer’s AGI exceeds $100,000 the $25,000 is reduced by $1 for every $2 that the taxpayer’s income exceeds $100,000 until the entire loss is disallowed at AGI of $150,000. For taxpayers married and filing separately the limits are $12,500 (instead of $25,000) and phase-out begins at $50,000 (instead of $100,000).
Conclusion
This article discusses very general questions relating to rental real estate losses. Many situations are unique and as always if you’re not sure of the rules, then check with a tax professional.
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By: Jeff Skolnick, CPA, M.S. Taxation
We are now through tax season, in my opinion, this is a good time for everyone to examine their personal tax situation. While most people saw their Federal income tax liability fall, some saw it rise and others even if they saw a decline in their taxes saw an even greater reduction in their withholding which led to a decreased refund or even a balance due. I will outline some areas that I believe individuals should take a look at in order to avoid surprises next April.
Self-Employment Tax
If you are an individual that is self-employed (sole proprietor or single member LLC) and you are subject to self-employment tax it is important to realize that the rate is approximately 14.1%. In addition, individuals that own interests in partnerships or LLCs may also be subject to self-employment tax. If an individual is subject to self-employment tax and does not account for this amount in their estimated tax payments it can be painful in April. I am therefore stressing to all those individuals that are subject to self-employment tax that they make quarterly estimated income tax payments to avoid pain and misery in April.
Additionally self-employed individuals always have a more difficult time estimating their current tax situation then do W-2 employees. Income can vary greatly year to year and you must monitor your individual situation in order to avoid surprises.
Changes in your personal situation
There may be changes in your personal situation that can affect your tax liability. An example of this might be the child tax credit. There is currently a $2,000 tax credit for children under the age of 17. Under the new law, many more people were able to take this credit based on more liberal income limitations. If you have a child that will reach age of 17 during the year the credit that you enjoyed this past tax season will not be available for you next April. It is very likely that you will still have a $500 credit, but you will not have a $2,000 credit. I also want to mention the income limitation on this credit although it is not nearly as important as it once was. Prior to the Tax Cuts and Jobs Act child care credits started to phaseout at $110,000 of Adjusted Gross Income for married couples filing jointly, $55,000 for married couples filing separately and $75,000 for everyone else. Under the new law the credit starts to phaseout for married couples filing jointly at $400,000 and $200,000 for all others.
Medical expenses are not deductible unless they exceed 10% of your income for tax years after 2018.
Most married couples filing jointly did not itemize and used the $24,000 standard deduction. This should be kept in mind as such things as charitable contributions, mortgage interest and real estate taxes may not impact your tax return as much as they did in the past.
In many instances individuals that have children in college are entitled to education credits either through the American Opportunity Credit or the Lifetime Learning credit. Both of these credits, however, have income limitations and therefore a credit you are counting on now may not be available to you. In some instances, it may make sense for a parent to not claim the child as a deduction and allow the child to claim the credit. While this may raise the tax liability on the parents, the overall taxes on the family may be lower. Additionally, the American Opportunity Credit is only available for the first 4 years of college and has a significantly higher income phaseout then the Lifetime learning Credit. Taxpayers should be alert as to how many years they have taken the American Opportunity credit and should plan for a potential reduced or completely phased out credit if they have already used the credit for 4 years.
Taxpayers should of course be reviewing their investment activity as well. If a taxpayer has any capital gains, they may want to start to look at stocks that are not doing as well that could be sold at a loss to offset the gains. This strategy is typically performed closer to yearend, but taxpayers should monitor their capital gains and losses during the year to allow enough time to plan to offset some of these gains.
If you were subject to the Alternative Minimum Tax (AMT) this past year, it is a good idea to take a look at your estimated income and deductions to see if this tax will apply, although far fewer individuals are subject to this tax now with the passage of the new law.
Lastly, it is always important to remember that if you have any significant income not subject to withholding (income from a sole proprietorship or single member LLC, income from a partnership, multiple Member LLC, S corporation, trust, or investment income such as interest, dividends or capital gains), then you will either have to increase the withholding on income that is subject to withholding or make quarterly estimated income tax payments.
Conclusion
If you found this year that your withholding was not sufficient to cover your liability you may have to increase your deductions or make quarterly estimated income tax payments in order to avoid being underpaid on your tax liability at yearend. You have over 8 months before yearend and almost a year before April 15th to remedy the situation which is much better than finding out a few weeks before your return is due. Once again if you’re not sure, then check with a tax professional to help determine your tax position.
I did an interview on RVN TV and shared my entrepreneurial journey with host Scott Aaron! Check it out here!
Article By: Jeff Skolnick, CPA, M.S. Taxation
One of the most common areas that I deal with each year is taxation upon the sale of a principal residence. I am going to outline some of the basics.
How much gain can I exclude from my income when I sell my house?
For married couples filing jointly that have owned and occupied the home as a principal residence for 2 of the last 5 years ending with the sale date, they can exclude the first $500,000 of gain. All others can exclude $250,000 assuming they meet the 2 out of 5 year rule. In addition, you must not have claimed an exclusion on any home in the last 2 years.
For purposes of the $500,000 exclusion, the ownership test is met if either spouse owns the home for 2 years. If only one spouse meets either the 2 year use test or has used the exclusion within the last 2 years then only the qualifying spouse is eligible for the exclusion and it is limited to $250,000.
I want to explain another situation that can occur with married couples. Let’s say each spouse owns a home entering the marriage and has satisfied the ownership and use requirements and also has not used the exclusion in the last two years. If each sells their own home and the couple purchases a new home each would be entitled to exclude $250,000 of gain on the sale of their former residence. Neither would be allowed a $500,000 gain as the spouse did not fulfill the use requirement (neither spouse used the other spouse’s former residence as a principal residence for 2 of the last 5 years).
Additionally, let’s say each spouse has owned their own home for the last 5 years and while they lived separately for the first 3 years of the 5 year look back and lived together for the last 2 years. Let’s also say that home they have lived together in for the last two years sold for a $350,000 gain, the other for a $200,000 gain and the couple bought a new house. In this instance they have a choice to exclude $250,000 of gain on one home and $200,000 on the second home or to exclude $350,000 on the home they lived in together. The reason they must make a choice is if they exclude $350,000 of gain as a married couple they cannot also exclude the $200,000 as each would have excluded a gain within the last 2 years. Obviously in this example it would make more sense to exclude $250,000 and $200,000 and pay tax on the $100,000 portion of the gain that exceeds the $250,000 limitation.
Another rule to keep in mind with spouses is upon the death of one spouse the remaining spouse can still exclude up to $500,000 of gain if the home is sold within two years of the death and the remaining spouse has not married.
One more thing to keep in mind for married couples (I know there a few but I want you to be well informed) is if one spouse dies the remaining spouse receives a step up in basis on their portion of the home. Let’s take an example where a couple purchased a home for $100,000 and it is worth $700,000 when the first spouse dies. The remaining spouse gets a basis of $350,000 on the first spouse’s portion (50% of the fair market value of $700,000) and $50,000 of their own basis (50% of the $100,000 basis). If the home is sold for $700,000 there would be a gain of $300,000 ($700,000 – $350,000 – $50,000). The surviving spouse could exclude all $300,000 if sold within 2 years of the first spouse’s death or $250,000 if the sale occurs later than 2 years after the first spouse’s death.
How do I calculate the gain or loss on the sale of my residence?
The gain or loss is calculated by starting with the gross sales price of the home, less any expenses of the sale (i.e. realtor commissions, attorney’s fees, realty transfer fees) less the basis of the house itself.
How do I calculate the basis of my home?
The basis of your home is generally the original cost plus any improvements you’ve made to the home. Each year clients call and want to deduct things such as updating a kitchen or bathroom and are disappointed when I tell them they can’t deduct these items. Upon the sale of the home is where these items help. In other words, let’s say you purchased a home for $350,000. Let’s further assume that you redid the kitchen ($30,000), 2 bathrooms ($20,000) and you also put $25,000 into landscaping and a new driveway. In this example the cost basis would be $425,000 ($350,000 + $30,000 + $20,000 + $25,000).
Assume a sales price of $700,000. Let’s also assume a realtor commission of 5% ($35,000) and additional expenses from the closing statement of $5,000. Sales price of $700,000 less $40,000 of expenses nets to $660,000. $660,000 less our previously calculated basis of $425,000 yields a gain of $235,000 and therefore no taxable income assuming the rules of using the property as a principal residence and prior use of this exclusion have both been met. Again keep in mind that a married couple filing jointly can exclude up to $500,000 of gain assuming both meet the tests outlined above
Other things to be aware of:
Even if you have had taken the exclusion within the last two years, you may be eligible for a reduced exclusion if your sale is the result of a change in employment, for health reasons or unforeseen circumstances. Additionally, there are special rules if you’ve used your residence for business purposes in the past.
Lastly, any loss you incur upon the sale of your residence is not deductible.
Conclusion
This article explains very quickly the basic principal residence sale rules, as always, I advise you to meet with a tax professional to help with these rules if you have any questions.
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