Table of Contents
- How to Report Rental Income for Taxes
- What is the Basis for my Rental Property?
- How Do I Determine Capital Gains Taxes when I Sell Rental Property?
- What is Depreciation?
- Rental Property Improvements vs. Repairs
- What is Depreciation Recapture?
- Do I Need to File a State Tax Return for My Rental Property?
- What is my Real Estate Exit Plan?
Service members and military families who purchase property often become landlords after a permanent change of station (PCS).
Sometimes renting makes the most sense financially, or it’s just the best of some bad choices if you’re unable to sell or would have to sell at a great loss.
But in my time as a tax advisor, I’ve found that few property owners fully understand how rental property taxes work before they begin renting.
My new clients who have rental houses often make errors handling the properties’ taxes. Tax errors on rental properties can be costly and frustrating if they’re discovered after the property’s sale.
If you have a rental property or are considering renting your property, this guide may help you identify or avoid common errors with your property and tax returns.
Remember that taxes only partially determine whether an investment is good or bad. This is especially true of rental property.
How to Report Rental Income for Taxes
The Schedule E (Supplemental Income and Loss) is the most common method for individual tax filers (as opposed to business filers) to report rental property income. But, short-term rental (STR) property owners may have to use Schedule C (Profit or Loss from Business) in some cases.
Whether you have long-term or short-term rentals, tax considerations are mostly the same. The first thing you need to determine is your basis.
The IRS provides plenty of guidance on both basis and gain. Good places to start for rental property owners (and would-be rental property owners) who want that guidance are IRS Publication 523: Selling Your Home, Publication 527: Residential Rental Property, and Publication 551: Basis of Assets.
What is the Basis for my Rental Property?
Your basis, according to the IRS, is the amount of your capital investment in your property for tax purposes. Put another way, it is the money you have put into the property (but not for repairs, maintenance and operating costs).
Initially, your basis is generally what you paid for the property, including certain purchase costs.
Additional costs – like property improvements (even those made well after purchase) may change the basis. When this happens, it’s called “adjusted basis.” The basis is adjusted higher by improvements and adjusted lower by depreciation and deducted casualty losses.
If your rental property used to be your primary residence, the IRS applies a special rule to determine your basis.
If you start renting out a house you used to live in, the rental property’s basis will either be the property’s price when you bought it, plus improvements, or your property’s market value at the time you converted it to a rental property – whichever is lower.
- If the purchase price was $200,000, but two years later (with no improvements) the home’s value is $300,000 when you start renting it out, the IRS wants you to use $200,000 for your basis.
- If you paid $300,000 for the property, but it’s worth $200,000 two years later when you start renting it out, the IRS wants you to use $200,000 for the basis.
This provision prevents a tax loophole.
The IRS wants you to use the lower basis so that you potentially pay more in taxes when you sell. Otherwise, property owners could avoid a lot of taxes in areas where home values increase significantly.
How Do I Determine Capital Gains Taxes when I Sell Rental Property?
You need to determine and track your basis properly to calculate your gain – that’s how much you’d make if you sold the property.
The IRS may tax some or all of your gain, so you’ll want to calculate it accurately. The higher the gain the more taxes you’ll pay. The higher your basis, the lower your gain and taxes when you sell.
Your gain is equal to your sale price, minus your (adjusted) basis and selling expenses.
Here is a simple example to illustrate the impact of basis.
Let’s assume this is the same house. In the first scenario, the property owner kept no records of home improvements to track the home’s basis. In the second scenario, they did.
- If you spent $120,000 on a home and sold it at $200,000, your gain would be $80,000. If your gain was taxed at 15%, you’d pay $12,000 because that $80,000 gain is what gets taxed, not the $200,000.
- If you spent $120,000 on a home, then spent an additional $30,000 improving it (to a total of $150,000) before you sold it for the same price of $200,000, your gain would be $50,000. If your tax rate on the gain is still 15% you’d pay just $7,500, because your improvements increased your basis, reducing your gain and your capital gains tax.
Which would you rather pay?
But, it isn’t always that simple.
The IRS (and the tax code) tells you how to determine your adjusted basis and what you can deduct from it. Publication 523 is the best place to start figuring out your capital gains taxes.
It’s a good idea to keep a running spreadsheet estimating your gains if you choose to sell and update it periodically – maybe once or twice a year.
You don’t want to end up paying extra or unnecessary capital gains taxes.
When are Capital Gains Excluded from Taxation When Selling Rental Property?
Normally the IRS expects you to pay taxes anytime you sell an asset with a profit or gain. But, most homeowners can have their capital gains excluded from taxation. This exclusion can help homeowners who decided to move from a home they owned during normal life changes.
The homeowner’s exclusion of capital gains, also known as the five-year rule, works like this: If an individual tax filer owned and lived in the home for at least two of the last five years and then sold it, up to $250,000 of capital gains may be exempt from taxation. A married couple filing jointly in the same situation can exclude up to $500,000 of capital gains.
There are some exceptions to the two-year rule, where you can exclude part of your capital gains if you lived in the rental home for less than two years. The IRS provides a worksheet and calculation to determine partial exclusions. In some cases, this calculation may still allow you to avoid capital gains entirely.
One of these is a military exclusion or suspension, which allows service members to suspend the five-year rule for up to 10 years when on qualified extended duty, effectively making it a “two out of 15 years” rule.
To qualify, you must have made a permanent change of station (PCS) greater than 50 miles from the home.
Using a partial exclusion or military suspension will complicate your tax returns. Both individuals filing their own tax returns and tax professionals have experienced errors of omission and application for these provisions.
Again, check out IRS publication 523, and don’t be afraid to consult with a tax professional if you don’t understand.
What is Depreciation?
One more complication for the basis for rental houses:
The tax code requires landlords to separately track the basis for rental houses and the land the homes are on.
Aside from the tax code, depreciation is another good reason to do this.
Depreciation is when you deduct part of the cost of a property over a period of years. Most residential rental property in the United States is depreciated over 27-and-a-half years, so 3.636% of the starting basis is deducted from each year to reduce income or create a loss.
But, land doesn’t depreciate at all. That’s why you track it separately.
You also need to depreciate any improvements you make to the house. Of course, the IRS tells you what is and what is not a property improvement.
Rental Property Improvements vs. Repairs
Generally speaking, if work you’ve done on your rental property increases its value, it is an improvement. Some examples include a new roof, a new bedroom addition, or a new HVAC system.
Fixing your plumbing or HVAC system, replacing a relay or other home repairs don’t increase your property’s value.
Knowing the difference between an improvement or repair is important for two reasons.
First, improvements increase the basis and thus reduce your gain and the property’s taxes if you go sell the home later. Second, an improvement can and usually is depreciated.
Remember, that means that you have to spread the cost of the improvement over a series of years.
Here’s what that might look like:
Say you put up a fence that costs $15,000 for labor and materials. This gets depreciated over 15 years.
Instead of deducting a $15,000 expense the year, the fence is built, you’ll take a $1,000 deduction each year for 15 years. You can use a depreciation schedule to track and calculate this process. The tax code and the IRS provide depreciation rates, but the math is often more complicated than this example.
The number of years to depreciate an improvement varies by type. The IRS provides details on the depreciation timeframes for assets in Publication 946. According to the IRS, costs for a fence spread over 15 years, as an example. Costs for a new roof (for residential rental property) will spread over 27 and half years.
But, there are safe harbor provisions that allow you to deduct some improvements from your taxes in one year, giving you the full tax benefit at once, instead of spreading it over many years through depreciation. IRS Publication 535 details these provisions.
There are also special depreciation options that can allow you to deduct costs faster. Both safe harbor provisions and the special depreciation options can be difficult to navigate. The tax code regarding these provisions changes frequently.
Smart tax planning can save you money over time by determining whether or not depreciating gives you the best net benefit.
When to Depreciate Rental Property Improvements
Let’s say that you have a $5,000 improvement that you can choose to depreciate over 15 years or deduct in one year.
If you move up a tax bracket in that year, then it may be of more value for you to expense the full $5,000. But if you know you will have plenty of income going forward with higher tax rates, you may offset that future income each year by depreciating over 15 years.
IRS Publication 527 is a good starting point for deciding whether to depreciate or deduct the expense all at once (and how to do it). It’s complicated though, so again, reach out to a tax pro if you need help.
Common Depreciation Errors On Rental Property Taxes
Military landlords often add depreciable assets to the rental property as they make improvements to the property. Again, tracking the basis here is important.
If you use the wrong basis, you could accidentally depreciate the wrong amount. Often, this is discovered later and can be complicated and costly to fix. You could owe back taxes, penalties and interest.
Similarly, depreciating an improvement at the wrong time or failing to depreciate an improvement can cause you to miss out on lower taxes. If you have rental losses, you can use them to lower your net income or carry the losses over to future years to lower their taxes later.
Finally, don’t skip depreciation to simplify your taxes. If you do, you won’t get the tax benefit for depreciation, but you’ll still get hit with depreciation recapture.
What is Depreciation Recapture?
Depreciation recapture is how the IRS recoups some of the tax benefits of depreciation from taxpayers.
You’ll pay depreciation recapture when you sell your property for a profit.
Depreciation recapture taxes your gain at a higher rate (up to 25% for depreciable real estate) than the long-term capital gains rate. You’ll owe the IRS depreciation recapture whether or not you depreciated assets on your taxes – often, even if you’re exempt from capital gains tax.
If you have made an error with depreciation the IRS has provided a method to fix it. However, depreciation errors often require more than just filing an amended tax return, so I recommend consulting a tax professional with experience in this area if you need to fix depreciation mistakes.
Do I Need to File a State Tax Return for My Rental Property?
Service members can maintain their state of legal residence through their period of service and PCS moves, thanks to the Servicemembers Civil Relief Act. Spouses can also often claim their service member spouse’s state of residency for their own taxes.
However, some states require landlords to file a non-resident tax return when there is income sourced to that state, including rental properties. Check the tax requirements for the state where your property is located to avoid any unwelcome surprises when you sell it. If you discover you missed taxes when you sell, it may require extensive effort to correct, along with back taxes and penalties.
What is my Real Estate Exit Plan?
When you have rental property, having an exit plan is a good idea.
You can delay capital gains taxes and depreciation recapture when selling a rental property with a 1031 exchange.
A 1031 exchange allows you to take the gains from your rental property and invest them in another one.
But, there are rules and procedures for this. Your 1031 exchange has to be in motion before you sell your rental property – you can’t just decide to do a 1031 exchange after you’ve sold a property.
But, the 1031 exchange isn’t an exit from real estate investing. If you want to completely exit real estate investing and renting, you can do it after you’ve made enough money that the tax burden feels bearable, or keep a rental property until you die.
In that case, your heirs would inherit the property at full market value. Then, if they sell it quickly, they can sell without any capital gains or capital gains taxes. They can also avoid depreciation recapture.
Due diligence is the key to eliminating or at least reducing rental property tax problems.
Make sure you understand tax situations before they situations occur. If you aren’t tax-savvy or simply don’t have the time or desire to dig into the manuals and the tax code, then having a tax professional with both military and rental property experience may be the best choice.