Investing in rental properties – both residential and commercial – can yield a variety of tax benefits. Your money can multiply, as you take advantage of all the tax breaks offered by the IRS. You do need some know-how, though, to help make your investment property pay off.
When you purchase property and rent it out, you're essentially running a business. You take in revenue — namely rent from your tenants — and incur expenses from the property. You hope that, over time, your revenue exceeds your expenses so that your real estate investment produces a profit (cash flow, in real estate lingo) for all the money and time you've sunk into it. You also hope that the market value of your investment property appreciates over time. The IRS helps you make a buck or two through a number of tax benefits. The major benefits follow.
Operating expense write-offs
In addition to the deductions allowed for mortgage interest and property taxes, just as on a home in which you live, you can deduct on your tax return a variety of other expenses for rental property. Almost all these deductions come from money that you spend on the property, such as money for insurance, maintenance, repairs, and food for the Doberman you keep around to intimidate those tenants whose rent checks always are "in the mail."
But one expense — depreciation — doesn't involve your spending money. Depreciation is an accounting deduction that the IRS allows you to take for the overall wear and tear on your building. The idea behind this deduction is that, over time, your building will deteriorate and need upgrading, rebuilding, and so on. The IRS tables now say that for residential property, you can depreciate over 27-1/2 years, and for nonresidential property, 39 years. Only the portion of a property's value that is attributable to the building(s) — and not the land — can be depreciated.
For example, suppose that you bought a residential rental property for $300,000 and the land is deemed to be worth $100,000. Thus the building is worth $200,000. If you can depreciate your $200,000 building over 27-1/2 years, that works out to a $7,272 annual depreciation deduction.
If your rental property shows a loss for the year (when you figure your property's income and expenses), you may be able to deduct this loss on your tax return. If your adjusted gross income is less than $100,000 and you actively participate in managing the property, you're allowed to deduct your losses on operating rental real estate — up to $25,000 per year. Limited partnerships and properties in which you own less than 10 percent are excluded.
To deduct a loss on your tax return, you must actively participate in the management of the property. This rule doesn't necessarily mean that you perform the day-to-day management of the property. In fact, you can hire a property manager and still actively participate by doing such simple things as approving the terms of the lease contracts, tenants, and expenditures for maintenance and improvements on the building.
If you make more than $100,000 per year, you start to lose these write-offs. At an income of $150,000 or more, you can't deduct rental real estate losses from your other income. People in the real estate business (for example, agents and developers) who work more than 750 hours per year in the industry may not be subject to these rules.
 | You start to lose the deductibility of rental property losses above the $100,000 limit, whether you're single or married filing jointly. You can carry the loss forward to future tax years and take the loss then, if eligible. This policy is a bit unfair to couples, because it's easier for them to break $100,000 with two incomes than for a single person with one income. Sorry — this is yet another part of the marriage tax penalties! |
Rollover of capital gains on rental or business real estate
Suppose that you purchase a rental property and nurture it over the years. You find good tenants and keep the building repaired and looking sharp. You may just find that all that work pays off — the property may someday be worth much more than you originally paid for it.
 | However, if you simply sell the property, you owe taxes on your gain or profit. Even worse is the way the government defines your gain. If you bought the property for $100,000 and sell it for $150,000, you not only owe tax on that difference, but you also owe tax on an additional amount, depending on the property's depreciation. The amount of depreciation that you deducted on your tax returns reduces the original $100,000 purchase price, making the taxable difference that much larger. For example, if you deducted $25,000 for depreciation over the years that you owned the property, you owe tax on the difference between the sale price of $150,000 and $75,000 ($100,000 purchase price minus $25,000 depreciation). |
All this tax may just motivate you to hold on to your property. But you can avoid paying tax on your profit when you sell a rental property by "exchanging" it for a similar or like-kind property, thereby rolling over your gain. The section of the tax code that allows rollovers is a 1031 exchange. (You may not receive the proceeds — they must go into an escrow account.) The rules, however, are different for rolling over profits (called 1031 exchanges, for the section of the tax code that allows them) from the sale of rental property than the old rules for a primary residence.
Under current tax laws, the IRS continues to take a broad definition of what like-kind property is. For example, you can exchange undeveloped land for a multiunit rental building.
 | The rules for properly doing a 1031 exchange are complex. Third parties are usually involved. Make sure that you find an attorney and/or tax advisor who is expert at these transactions to ensure that you do it right. |
Real estate corporations
When you invest in and manage real estate with at least one other partner, you can set up a company through which you own the property. The main reason you may want to consider this setup is liability protection. A corporation can reduce the chances of lenders or tenants suing you.
Tax credits for low-income housing and old buildings
| The IRS grants you special tax credits when you invest in low-income housing or particularly old commercial buildings. The credits represent a direct reduction in your tax bill because you're spending to rehabilitate and improve these properties. The IRS wants to encourage investors to invest in and fix up old or rundown buildings that likely would continue to deteriorate otherwise. |
The amounts of the credits range from as little as 10 percent of the expenditures to as much as 90 percent, depending on the property type. The IRS has strict rules governing what types of properties qualify. Tax credits may be earned for rehabilitating nonresidential buildings built in 1935 or before. "Certified historic structures," both residential and nonresidential, also qualify for tax credits. See IRS instructions for Form 3468 to find out more about these credits.
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