End of year tax planning
It’s always a good idea to start planning for April 15th now, close to the end of the year, to determine how best to maximize your investment property tax deductions. November/December is a great time to make an appointment with your accountant before they are consumed with work come January through April. Maybe they will have some new suggestions about how best to maximize your day to day expenses to help offset your cash flow income, realizing a smaller tax bite on your rental property come tax time. Whether you have a typical investment rental property or even some vacation home rentals, now is the time to start your tax planning.
Remember to keep excellent records throughout the year on each of your rental properties. In addition, keep records even if you don’t purchase a particular property in any given year. You can add those expenses in when you eventually do acquire a property, as part of your cost “basis” (more on cost basis as part of capital improvements below).
You should also know that all expense items are deductible from revenue, thereby lessening your overall profit (and therefore, tax bite) on any given rental property in a calendar year. Maintenance costs, such as plumbing or electrical repair work, landscaping, snow removal, etc. are all examples of ongoing yearly expense items. In addition, auto expenses incurred while looking for properties can be considered part of your overall expense deductions in any given tax year. Also, all office costs, such as your computer, printer, phone, phone bill, internet bill, office furnishings, etc. are also expense items. And don’t forget that any property management fees are expenses that are deductible in the given tax year you are reporting as well, whether in standard residential home rentals or in vacation rental homes.
Expenses versus capital improvements
However, keep in mind that your renovation/rehab costs are not expensed as yearly items – they are lumped in with your other property acquisition costs, and are known as capital improvements. They comprise the cost basis of the rental property. When it comes time to sell your building, all of your basis costs over the years you owned your rental property will be taken together and subtracted from the amount you sell your rental property for – thus yielding a capital gain. Capital gains are taxed at lower levels than personal income, so any item you can add to the cost basis needs to be carefully itemized, tracked and recorded. In this way, you’ll have a completely accurate amount for the cost basis of any given rental property you acquire.
Assuming you did manage a profit when you sold your rental property and you held the property for at least a year, you’ll pay only the capital gains tax. In 2014, this tax rate is 15% (or 20% if your taxable income as a single taxpayer is above $400,000, or $450,000 if married and filing jointly). In addition, you’ll have a surtax added to pay for Medicare – an added 3.8% of your profit if your taxable income is over $200,000, or $250,000 if married.
This is where things get fun for the property investor. Depreciation, or the amount ascribed to “wear and tear” on your rental property each year, is strictly a paper number. You did not actually fork out any money, yet you derive the benefit of deducting an amount for depreciation on each of your buildings each year. This paper deduction results in a lower positive cash flow, and concomitantly, a lower tax bill. Be sure to check with your tax advisor/accountant to help determine the actual depreciation on each of your investment properties. Commercial buildings will have different depreciation schedules than residential rental properties. In addition, different types of residential properties may have inherently longer life spans, and may call for a unique depreciation schedule for each one. (Of course, eventually you “pay” for the depreciation deduction. When it comes time to sell your property, the total amount you’ve deducted in depreciation over the years gets subtracted from your cost basis, an accounting maneuver known as “recapture.”)
Converting to a primary residence
If you lived in your former rental property for at least two years, you can claim a part of the standard home $250,000 exclusion for your primary residence (or $500,000 if married and filing jointly) when it comes time to sell it. This exclusion will be prorated based on the length of time you lived in it versus how long you actually owned the property. So if you owned it for 10 years, but lived in the home rental property for 5 years, you’d be able to claim 50% of the exclusion. Again, it is smart to check with your tax advisor for further advice on how to save from overpaying the IRS on your rental properties.
A good way to avoid capital gains on the sale of your property is to buy more investment property through swapping like property. In section 1031 of the IRS code, one is allowed to carry the cost basis forward from a newly–sold property to a newly-bought property without having to pay taxes on the sale. There are however, many IRS rules regarding how the monies are held between the sale and purchase, as well as strict time lines for this to be acceptable. Make sure you check with your tax advisor regarding the exact way to accomplish this tax deferment.
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