Rental Real Estate Taxation

Residential real estate (i.e., single-family and multi-family residences) is commonly owned as investment property for the purpose of collecting cash in the form of tenant lease payments.  Investors should be aware of the following income tax issues unique to this asset class.

Rental Real Estate

Depreciation.  Real estate held for investment purposes is subject to annual depreciation deductions.  This non-cash expense can be taken over a 27.5 year period for residential property, while commercial real estate can be depreciated over 39.5 years.  Annual depreciation deductions are calculated as a percentage of the cost of the property (only the building is depreciable, as the land on which the building sits is not depreciable property).  One downside to depreciating real estate held for investment is the requirement that accumulated depreciation deducted during the holding period must be recaptured and taxed as ordinary income.  Nevertheless, depreciation deductions on rental real estate can be lucrative benefits of this type of investment.

Losses from Rental Real Estate.  The tax consequences resulting from rental real estate losses can be complex.  In general, income received from rental real estate is treated as passive in nature.  The significance of this classification arises when a taxpayer realizes a net loss from a property.  According to Internal Revenue Service (IRS) regulations, losses attributable to rental real estate (i.e., passive activity losses) are only deductible against income treated as passive in nature.  Excess passive losses are suspended and carried over to the following year.  There are several exceptions to the general rule limiting the deductibility of passive activity losses, as follows:

  1. Active Participation Exception – Taxpayers that actively participate in the management of their rental properties may be able to deduct up to $25,000 of losses against other income.  Active participation (not to be confused with material participation) involves making management decisions related to the taxpayer’s rental property.  Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditure, and similar decisions.  The $25,000 deduction of passive activity losses attributable to rental real estate is reduced by 50% of the amount of a taxpayer’s modified adjusted gross income (MAGI) in excess of $100,000, and this special allowance is completely phased-out (i.e., not allowed) for taxpayers with MAGI of $150,000 or more.
  2. Disposition of Rental Property Exception – Losses resulting from rental real estate (arising in either current year or prior years) are generally deductible against other income in the year a taxpayer disposes of his/her entire interest in the property.

Additional Resources

Passive Activity Losses from Rental Property by Dillon Wright

6 Exit Strategies For Your Rental Real Estate by Thomas Castelli

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