Rental Property Tax Strategies - First Time Filling

Josh M. · 2020-07-08T15:01:11-07:00

I apologize in advance for the number of questions. I have tried to phrase them in such a way that it provides my conclusion and I am mostly looking for confirmation.If a CPA wants to do a quick review my return and do a Q&A session over the phone in the next week, I will be happy to Venmo you for your "unofficial" review. PM me.My main concern is setting up something incorrectly that is going to cause headaches down the line or leave tax benefits on the table.Top Level Info:- Located in Texas- Married filing jointly; we both have W2 jobs- Converted primary residence into rental, placed in service on 3/15/2019- Rental Income is labeled as "Passive Activity", "Active Participant"- Net Income reported is showing 0- Loss of ~4,400 (paid 2018 property taxes in 2019)- Using TaxActGeneral Questions:- Qualified Joint Venture: I set up the business under me only. I owned the home before we were married so everything is in my name and am the more "active" participant in operating the rental property. Is there any benefit to setting up the rental as a "Qualified Joint Venture" between my wife and I vs. solely under me?- Personal Use: If I am understanding the guidance properly, I do NOT need to input any thing for Personal Use since it was placed into service after we moved out. Correct?- Repair Regulation Elections: I currently do not have any selected. Is there any benefit to choosing to Capitalize or the Small Taxpayer Harbor (I don't fully understand the requirements)?- Mortgage Costs: I claimed the 10 months it was in service. Should I claim the entire year since I technically owned the asset?- Asset acquired before 1987: The house was built before 1987 but I acquired the property in 2011 so I would answer it was acquired after 1987. Correct?- Amortization: I am currently claiming nothing. Are there items that are typically claimed on former primary residences that have been converted into rental?- Section 199A: I selected Section 199A and I do not believe it should be labeled as Safe Harbor since I did not spend more than 250 hours performing rental services. Correct?- Qualified Business Income Deduction / Adjustment: Answering the TaxAct prompts yielded $0 for 2019. Is that to be expected given my situation?Depreciation Questions:- Cost Basis: There have not been any material improvements since purchasing. My understanding is to take purchase price in 2011 * % of the house/improvement value from my current tax assessment?- Straight Line vs. Alternative: TaxAct and my reading suggested Straight Line since it is 100% business use. Correct?- Asset Life Years: TaxAct suggested 27.5 years. I plan to keep this as a rental long term (10+ years). The home was built in 1979, purchased by me in 2011. Does that seem correct?

Brian Davis

Accountant · Fort Lauderdale, FL (Virtual CPA Service) · Member since 2020 · 10 posts · 4 votes

6y

Josh-you are on the right track, and you're asking some great questions, here are some responses that I hope help out!

Personal Use - You are correct here. Nothing for personal use since it was placed in service after you moved out. Fair rental days will start from the day you placed in service until December 31st (Example: placed in service on March 15th, would mean 292 Fair Rental Days and 0 Personal Use days on your Schedule E)

Repair Regulation Regulations - This is where you let the IRS know how you will be treating your repair expenses ($2,500 or less) that are for the "betterment, restoration or adaption" of your property.

---Q: Should you deduct these expenses in full (100% deduction in 2019) or over time (capitalizing with depreciation over multiple years)?

---A: That depends on your overall tax strategy, overall income and tax situation (there are other rules limiting your overall deductible loss from rentals based on your income, other passive investment activity, etc). The good thing about this election is that you can choose to take it one year, opt-out the next year, then opt-in the year after--you decide every year by taking or not taking the election. Capitalizing adds to your basis, which could lower your taxable profit/capital gains tax if you are planning on selling in the near future. Capitalizing basically means you take deductions on those items over multiple years (instead of all at once in 2019). If you expect your taxable income (from other sources) to go up in future years, those deductions may save you more money if taken over time instead of all in year 1. So for this one it really depends.

Mortgage Costs - To be safe I would only take only the mortgage interest and real estate taxes from the date you placed it in service (March 15-December 31). The mortgage interest and real estate taxes you paid from January 1st through March 15th would be deductible on Schedule A if you are itemizing-I know most people are now using the standard deduction so those may not help.

Asset acquired before 1987 - You are correct here, they are asking if the property was acquired after 1987 (not the year built).

Amortization - This can be taken on those closing costs (see your 2011 Closing Statement) such as appraisal, inspection, title fees, loan origination fees, recording fees. Taken over the life of the loan, if you sell the property in let's' say 10 year, you will be able to deduct these in the year of the sale, so be sure to keep track of these. Are you including these in your depreciable cost basis? Some tax returns that I've seen include these as acquisition costs for depreciation basis instead of taken as amortization over the life of the loan. This doesn't make a huge difference to the bottom line (taking it as depreciation over 27.5 years vs. taking amortization over the life of the loan, usually a standard 30 year mortgage). Just make sure you are not double-dipping (taking the same deduction twice)!

Section 199A - Yes you are right on target with this. Since you don't meet the 250 hour requirement you will not be able to take the QBI deduction on this since it's not considered a "trade or business". The IRS clarified this last year for everyone, but yes you are correct. https://www.irs.gov/newsroom/irs-finalizes-safe-harbor-to-allow-rental-real-estate-to-qualify-as-a-business-for-qualified-business-income-deduction

Qualified Business Income Deduction / Adjustment - Yes, $0 for this sounds right. Section 199A or QBI -those are all talking about the same thing. This is the 20% deduction that was created by the 2017 Tax Cuts and Jobs Act. Based on your less than 250 hours you wouldn't qualify (this is a 20% deduction on the net rental profit, if any, after depreciation). Related to your rental property net taxable income, this is a usually a small number since net profit (for QBI calculation) is after depreciation and all of those other deductible expenses. To get a quick estimate of what ends up on your tax return I tell my clients to estimate: +positive cash flow, +(plus)principal pay down, -(minus) depreciation and amortization.

So don't worry that you can't take this deduction now, it may not be as much as you think. If you start investing more time >250 hours in the future, you'll probably have higher profits and you'll be able to take that 20% QBI deduction once you exceed that threshold.

Depreciation Questions:

Cost Basis - The IRS says the use the LESSER of Fair Market Value or your Adjusted Cost Basis (Fair Market Value - "This is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property." -from IRS Pub. 527). So you should only use the fair market value if it is lower than your adjusted basis.

Straight Line vs. Alternative - TaxAct is correct you should be depreciating the residential real property using 27.5 year straight-line. Remember the Land portion of your asset is not depreciable, and should be setup as a separate asset (Land) that does not depreciate.

Asset Life Years - Yes 27.5 is the straight line depreciation for residential rental property. Depreciation on major improvements (roof, bathroom remodel, kitchen, etc.) you have the options of taking those all in year one (De Minimis Safe Harbor <$2500), 100% Special Depreciation or over its' useful life.

One thing I must tell you to keep in mind for the near future, is that if you lived in the house for for 2 years out of the last 5 years (from the date of your a potential sale), you may qualify for an exclusion of $500,000 in profit if you sell that property. There would be a small depreciation recapture on the depreciation taken while you have it as a rental (Years 3-5) but other than that, this could mean a huge tax savings specifically for taxpayers who sell their primary residence at a gain, the proceeds can be used for investing in other properties, or anything else. This could potentially be a tax SAVINGS, different than a tax DEFERRAL (such as a 1031 exchange).

Just something to keep in mind as you get closer to that date and have to decide whether you want forego that savings to hold it long term, or sell it and use the proceeds for another property or multiple properties, etc.

-You'll notice I completely avoided your first question on Qualified Joint Venture! For that one I'd say to consult with a real estate attorney or maybe an attorney here on BiggerPockets can chime in to talk about the pros and cons of a QJV. The way I normally see this setup is as a Single Member (you) LLC, disregarded entity filing Schedule E (attachment to your Married Filing Jointly 1040). There are special rules for a QJV in community property states like where I am (in Florida), and for you (in Texas), so if that's something you want to explore further, I would consult with a TX attorney on that.

I'm a Tax Accountant (CPA) in Fort Lauderdale, FL and I invest in real estate in South Florida and Atlanta. I have clients that live and also have investment properties throughout the US, including Dallas.

1 Reply

Kevin Koffman

Investor · Fort Lauderdale, FL · Member since 2016 · 22 posts · 15 votes

6y

Wow... like... good answer, man. And right in the middle of tax time, too.

0 Reply

Brian Davis

Accountant · Fort Lauderdale, FL (Virtual CPA Service) · Member since 2020 · 10 posts · 4 votes

6y

@Kevin Koffman

Thanks! Yes by now all of my clients are either on extension for 2019 or all completed!

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Josh M.

OP

TX · Member since 2015 · 5 posts · 3 votes

6y

Originally posted by @Brian Davis:

Repair Regulation Regulations - This is where you let the IRS know how you will be treating your repair expenses ($2,500 or less) that are for the "betterment, restoration or adaption" of your property.

---Q: Should you deduct these expenses in full (100% deduction in 2019) or over time (capitalizing with depreciation over multiple years)?

---A: That depends on your overall tax strategy, overall income and tax situation (there are other rules limiting your overall deductible loss from rentals based on your income, other passive investment activity, etc). The good thing about this election is that you can choose to take it one year, opt-out the next year, then opt-in the year after--you decide every year by taking or not taking the election. Capitalizing adds to your basis, which could lower your taxable profit/capital gains tax if you are planning on selling in the near future. Capitalizing basically means you take deductions on those items over multiple years (instead of all at once in 2019). If you expect your taxable income (from other sources) to go up in future years, those deductions may save you more money if taken over time instead of all in year 1. So for this one it really depends.

No intention of selling for the foreseeable future. This is intent to be a long term rental properly and part of my retirement cash flow strategy. The mortgage will be paid off in ~6 years; it should conservatively cash flow $1000 per month. My timeline to retirement is 7-10 years.

I expect Taxable Income to be flat or increase until retirement.

My repairs and maintenance costs for this year were $2437.47. I cashed out a brokerage account and have a Capital Gain of $1362. If I choose to capitalize the expenses, can I offset the capital gain or is it only on the selling of the home?

Mortgage Costs - To be safe I would only take only the mortgage interest and real estate taxes from the date you placed it in service (March 15-December 31). The mortgage interest and real estate taxes you paid from January 1st through March 15th would be deductible on Schedule A if you are itemizing-I know most people are now using the standard deduction so those may not help.

I made the Tax Year 2018 payment in Jan 2019 then Tax Year 2019 payment in Dec 2019. To confirm, the Jan 2019 payment will not count if it was not yet placed in service - correct?

Amortization - This can be taken on those closing costs (see your 2011 Closing Statement) such as appraisal, inspection, title fees, loan origination fees, recording fees. Taken over the life of the loan, if you sell the property in let's' say 10 year, you will be able to deduct these in the year of the sale, so be sure to keep track of these. Are you including these in your depreciable cost basis? Some tax returns that I've seen include these as acquisition costs for depreciation basis instead of taken as amortization over the life of the loan. This doesn't make a huge difference to the bottom line (taking it as depreciation over 27.5 years vs. taking amortization over the life of the loan, usually a standard 30 year mortgage). Just make sure you are not double-dipping (taking the same deduction twice)!

I am not currently including them. I found my closing statement and my fees were $3,963.81. I could add these to Amortization?

I did refinance in 2016 (unable to located that closing statement digitally) but if I can, could I include those to Amortization as well?

Depreciation Questions:

Cost Basis - The IRS says the use the LESSER of Fair Market Value or your Adjusted Cost Basis (Fair Market Value - "This is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property." -from IRS Pub. 527). So you should only use the fair market value if it is lower than your adjusted basis.

Fair market value is close to $100k higher than what I paid in 2011. Good problem to have I suppose.

I can only see Assessed Values on the Tax website back to 2015. I emailed them requesting 2011. I found 2010 in my closing documents:

LAND 26,000
IMPROVEMENT 89,100
TOTAL VALUE 115,100

Which puts the land value around 22.5% so I could use that ratio x Purchase Price?

One thing I must tell you to keep in mind for the near future, is that if you lived in the house for for 2 years out of the last 5 years (from the date of your a potential sale), you may qualify for an exclusion of $500,000 in profit if you sell that property. There would be a small depreciation recapture on the depreciation taken while you have it as a rental (Years 3-5) but other than that, this could mean a huge tax savings specifically for taxpayers who sell their primary residence at a gain, the proceeds can be used for investing in other properties, or anything else. This could potentially be a tax SAVINGS, different than a tax DEFERRAL (such as a 1031 exchange).

Just something to keep in mind as you get closer to that date and have to decide whether you want forego that savings to hold it long term, or sell it and use the proceeds for another property or multiple properties, etc.

I am aware of the 2/5 year rule. I plan to evaluate closer to that 5 year mark but as mentioned above, my intention is to hold and operate as a rental for an extended period of time. Is the rule calendar year or to the date of being your primary residence?

First of all - THANK YOU!!!

I edited the quote above to only include where I responded, which is underlined.

One additional "macro" question about Cost Basis - If this is a long term rental (10+ years), is it better to have a larger or smaller cost basis?

I appreciate your help.

0 Reply

Dave Toelkes

Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes

6y

@Josh M.

It appears that your property taxes are paid in arrrears. All of your 2018 property tax bill paid in 2019 would be deducted as a personal expense on Schedule A if you itemiize. For 2019, you have three months of personal use and nine months of rental use. Allocate your 2019 tax bill between the periods of personal use and rental use. The personal use question in your tax software is designed to help you allocate certain annual expenses between personal and rental use. For example, if you tell the tax software that your first year was 90 days personal use and 275 days rental use, then the software will take your annual tax bill and annual hazard insurance premium and allocate those amounts between your personal use and rental use and put the appropriate amounts on Schedule A and Schedule E. If you want to manage the allocation yourself, then answer 0 to the personal use question.

Amortization applies to the costs of refinancing. Loan fees and other closing costs when you originally purchased the home should already be included in your original tax basis for the property. If you did not refinance the property, you have no amortization costs to expense.

Basis for depreciation is your adjusted tax basis OR the FMV of the property whichever was less at the time of conversion from personal use to rental use. Your tax basis (or FMV) minus the portion allocated to the land is the depreciation basis for the dwelling structure. If you did any capital improvements (not repairs) to the home while it was your primary residence, then the cost of those improvements would be added to your depreciation basis for the dwelling structure. The IRS will accept use of the tax assessor's ratio of the dwelling structure to the property value times your original tax basis (or FMV if lower) to determine the depreciation basis for the dwelling structure. Whatever method you use to determine your depreciation basis must be defendable to the IRS should you get audited, so don't get too creative here.

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Josh M.

OP

TX · Member since 2015 · 5 posts · 3 votes

6y

Thanks @Dave Toelkes!

After the Trump tax changes, I no long itemize.

For Amortization, I purchased in 2011 and refinanced in 2016 all as my primary residence. I have not established my original tax basis. I am trying to figure that out now. So can I retroactively amortize those costs?

When you all mention "actual basis" - are you referencing the county tax appraisal at the time of purchase (4/2011) or when it was placed into service (3/2019)?

Fair market value is significantly higher than even appraised value right now.

0 Reply

Brian Davis

Accountant · Fort Lauderdale, FL (Virtual CPA Service) · Member since 2020 · 10 posts · 4 votes

6y

No intention of selling for the foreseeable future. This is intent to be a long term rental properly and part of my retirement cash flow strategy. The mortgage will be paid off in ~6 years; it should conservatively cash flow $1000 per month. My timeline to retirement is 7-10 years.

--Awesome, with all of that equity your balance sheet will look good, you'll have good equity in the property which would help get into your next one and then the next one.

I expect Taxable Income to be flat or increase until retirement.

--If that's the situation, I would opt to take those deductions in year 1. Better to get the tax savings now, and have more money to invest than to save the deduction for the future when it will save you the same amount in the future. This is just my preference, you can decide deduct them all at once or over time. I sometimes run into situations where a client expects a future capital gain, inheritance, a bonus, etc. in the future year, or years, where they know the future tax rate will be higher than the current year. In that case I suggest taking the deductions over time.

My repairs and maintenance costs for this year were $2437.47. I cashed out a brokerage account and have a Capital Gain of $1362. If I choose to capitalize the expenses, can I offset the capital gain or is it only on the selling of the home?

Correct, those are not available to offset capital gains unless you "Dispose" of those, example: when you sell the property.

I made the Tax Year 2018 payment in Jan 2019 then Tax Year 2019 payment in Dec 2019. To confirm, the Jan 2019 payment will not count if it was not yet placed in service - correct?
Generally you take deductions in the period they were PAID not accrued, so if you paid 2018 in Jan. 2019, that would be an Itemized Deduction, the 2019 taxes paid in December 2019, deduct that in full on Schedule E.

I am not currently including them. I found my closing statement and my fees were $3,963.81. I could add these to Amortization?

I would normally suggest that you include those and amortize over the period of the loan (ex. 30 years). If the loan was closed/rolled into your refinance in 2016, use those 2016 loan costs, not the original $3,963.81 loan costs.

I did refinance in 2016 (unable to located that closing statement digitally) but if I can, could I include those to Amortization as well?

Yes, take those as well, over the loan period

Fair market value is close to $100k higher than what I paid in 2011. Good problem to have I suppose.

Yes, the best problem appreciation on a depreciable property!

I can only see Assessed Values on the Tax website back to 2015. I emailed them requesting 2011. I found 2010 in my closing documents:

LAND 26,000
IMPROVEMENT 89,100
TOTAL VALUE 115,100

Which puts the land value around 22.5% so I could use that ratio x Purchase Price?

Yes that would be a good method for segregating building (27.5 year depreciation 77.5%) and Land (No Depreciation-22.5%). But use your Purchase Price (this is what I mean by Adjusted Basis), not the assessment or Fair Market Value, because the rule is to use the LESSER of those two (Adjusted Basis or Fair Market Value) for basis on your taxes

I am aware of the 2/5 year rule. I plan to evaluate closer to that 5 year mark but as mentioned above, my intention is to hold and operate as a rental for an extended period of time. Is the rule calendar year or to the date of being your primary residence?

5 years from the date, not the calendar year, so you would need to sell and close by March 14, 2022 to use that homeowners primary residence exclusion

1 Reply

Josh M.

OP

TX · Member since 2015 · 5 posts · 3 votes

6y

Thanks again @Brian Davis ! I found by 2016 refi closing statement and I think I have all of my question answered except one...

Removing the land value, why would I use purchase price (4/2011) vs. appraised value when it was placed into service (3/2019) to establish my basis?

1 Reply

Dave Toelkes

Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes

6y

@Josh M.

The depreciation basis is determined by the lower of

what you actually paid for the property, or,
its FMV at the time it is converted to rental use.

1 Reply

Brian Davis

Accountant · Fort Lauderdale, FL (Virtual CPA Service) · Member since 2020 · 10 posts · 4 votes

6y

@Josh M.

IRS Rules-You must use the lower of the two.

0 Reply

Ronald RohdePro Member

Attorney · Dallas, TX · Member since 2016 · 5k+ posts · 2k+ votes

6y

Side note, are you holding title individually or entity (LLC)?

0 Reply

Josh M.

OP

TX · Member since 2015 · 5 posts · 3 votes

6y

@Ronald Rohde I hold the title individually.

Taxes are filed. Thank you all for your help!

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Rental Property Tax Strategies - First Time Filling

Rental Property Tax Strategies - First Time Filling

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