Owning a real estate rental property has its tax advantages. From mortgage interest, depreciation, to property taxes and operation and maintenance costs, you can save money by rightly claiming deductions.
But your tax treatment depends on your investor type. Are you a passive investor or a real estate professional? The way you work influences how the Internal Revenue Service (IRS) treats your income and losses. Real estate is generally a passive activity. But the degree of your participation impacts the tax treatment of generated income and losses from the property.
The IRS defines a real estate professional as someone who spends over half their working hours in rental businesses. This encompasses property development, construction, acquisition, and management. To qualify as a professional, you must dedicate over 750 hours yearly to your rental properties.
As a real estate professional, your activities aren't seen as passive. Your income is rather treated as active (non-passive) income. Therefore, you can use losses to offset other income types and evade the 3.8% net investment tax if the rental yields income.
If you materially participated as a real estate professional, your rental property engagement receives non-passive tax treatment, implying you can use any losses to offset other income types. You're also not liable to net investment tax.
Being an active participant means that you make significant and bona fide management decisions that can enable the deduction of some of your passive losses. If you possess at least a 10% interest in the investment, and your modified adjusted gross income (MAGI) is less than $100,000, you could deduct up to $25,000 of passive losses. However, this deduction starts to phase out if your MAGI is between $100,000 and $150,000, and you can't take any passive losses once your MAGI exceeds $150,000.
However, if your rental property is just an investment on the side, and you don’t play a major role in the investment, it’s categorized as a passive activity. In such a case, passive activity losses can only be used to offset passive activity income.
As an owner of a rental property, you should report all of your rental income, which does not merely cover monthly rent checks, but also includes advance payments.
You can increase your savings by factoring in deductions related to the purchase, operation, and preservation of the property. Examples include mortgage interest on your first/second home or investment properties, repair costs, depreciation, operating expenses, and other common expenses.
The IRS urges rental property owners to keep documents like appointment books, diaries, calendars, and logs as evidence of active participation.
Overall, understanding the tax implications associated with rental property ownership can contribute significantly to improving your bottom line. It's highly advised to seek guidance from a tax professional for tailored advice.