Economic fallout from the COVID-19 crisis will cause many rental real estate properties to run up tax losses in 2020 — and possibly beyond. Here's a summary of important federal income tax rules for such losses.
Rental property owners can deduct mortgage interest and real estate taxes. They can also write off all standard operating expenses that go along with owning rental property. Examples include:
For many rental property owners, the tax kicker is the depreciation deduction. That is, the cost of a rental building (not the land) can be depreciated over 27.5 years for a residential building and over 39 years for a commercial building — even while the property increases in value over time. Depreciation write-offs can deliver significant tax savings, especially if you own several properties.
For example, Ann owns an apartment building that cost $750,000, not including the land. Her annual depreciation deduction is $27,273 ($750,000 divided by 27.5 years). Each year, that deduction can be used to shelter up to $27,273 of positive cash flow from income taxes.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act includes a retroactive correction to the statutory language of the Tax Cuts and Jobs Act (TCJA). The correction allows much faster depreciation for commercial real estate qualified improvement property (QIP) that's placed in service in 2018 through 2022.
QIP is defined as an improvement to an interior portion of a nonresidential building that's placed in service after the building was placed in service. However, it doesn't include any expenditures attributable to:
Thanks to the CARES Act correction, you can write off the entire cost of QIP in the first year it's placed in service, because it now qualifies for 100% first-year bonus depreciation. Alternatively, you can depreciate QIP over 15 years using the straight-line method.
Important: The CARES Act correction retroactively applies to QIP placed in service in 2018 and 2019. Before the correction, QIP placed in service in those years generally had to be depreciated over 39 years.
For eligible property placed in service in tax years beginning after 2017, the TCJA increases the maximum Section 179 deduction to $1 million, with annual inflation adjustments. The inflation-adjusted maximum for tax years beginning in 2020 is $1.04 million. The Sec. 179 deduction privilege allows you to write off the entire cost of eligible property in the first year it's placed in service.
The TCJA also expanded the definition of eligible property to include expenditures for:
Finally, the TCJA further expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples of such property include beds, other furniture and appliances used in the living quarters of a lodging facility (such as an apartment building).
Most new properties operate at a loss while they're trying to find tenants. Losses are also common when the economy falters, causing tenants to miss rent payments and vacancy rates to increase. Rental losses can complicate your tax situation, especially if the so-called passive activity loss (PAL) rules come into play.
Losses from rental properties will usually be classified as passive losses. In general, the PAL rules allow you to deduct passive losses only to the extent that you have passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either 1) have more passive income, or 2) sell the property that produced the losses.
As a result, the PAL rules can postpone any tax benefit from rental property losses, sometimes for many years. Fortunately, there are several exceptions that can allow you to deduct rental property losses sooner rather than later. Your tax pro can explain the exceptions and help you plan to become eligible, if possible.
The TCJA established another hurdle to clear to currently deduct your rental property losses: For tax years beginning in 2018 through 2025, you can't deduct an "excess business loss" in the current year. This term refers to a loss that exceeds $250,000 or $500,000 for a married joint-filing couple.
Under the TCJA, any excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards. This loss disallowance rule applies after applying the PAL rules. So, if the PAL rules disallow your rental losses, this rule doesn't matter.
Important: The CARES Act suspends the excess business loss disallowance rule for losses that arise in tax years beginning in 2018 through 2020.
If your rental property losses clear both the PAL and excess business loss hurdles, those losses can be used to offset taxable income from other sources. If losses for the year exceed income from other sources, you may have an NOL for the year.
Important: The CARES Act allows a five-year carryback privilege for an NOL that arises in a tax year beginning in 2018 through 2020. So, you can carry an NOL from one of those years back to an earlier year, deduct it, and recover some or all the federal income tax paid for the carryback year. Because federal income tax rates were generally higher in years before the TCJA took effect, NOLs carried back to those years can be especially beneficial.
The economic fallout from the COVID-19 crisis increases the odds that your rental properties will incur losses in 2020, but special tax relief provisions may soften the blow. If you have questions or want more information, consult your tax professional.
Despite the COVID-19 crisis, some properties will generate positive taxable income, instead of losses, in 2020 and beyond. This happens when rents surpass deductible expenses. (See main article.)
Of course, you must report those profits as passive taxable income. But, if you've accumulated suspended passive losses from earlier years, you now get to use them to offset your passive income.
Another upside is that taxable income from rental real estate isn't subject to self-employment (SE) tax. The SE tax, which can be up to 15.3%, applies to most other unincorporated profit-making ventures.
However, passive income from rental real estate owned by higher-income individuals may be hit with the 3.8% net investment income tax (NIIT). Gains from selling properties also may be subject to the NIIT. Consult your tax advisor for details.
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Many rental properties are owned by so-called "pass-through" entities, such as sole proprietorships, limited liability companies (LLCs) treated as sole proprietorships for tax purposes, partnerships, LLCs treated as partnerships for tax purposes and S corporations. Your share of net income from a pass-through entity is passed through to you and reported on your personal return.
For 2018 through 2025, the Tax Cuts and Jobs Act (TCJA) established a new personal deduction based on qualified business income (QBI) from a pass-through entity. The deduction can be up to 20% of QBI, subject to restrictions that can apply at higher income levels.
Last year, the IRS set forth a safe-harbor provision that allows QBI deductions based on net income generated by eligible rental property activities that are owned via pass-through entities. Many rental property activities will be eligible for the safe-harbor provision, but some complicated rules must be followed. Consult your tax advisor for more information.
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