Real Estate Investments & Taxes Presented by: Erica Bartz, Realtor, EA, CFE

What we will be covering today? What is the difference between rental income and earned income? What is included in income? Common expenses & IRS expectations for documenting expenses. When can a repair be expensed vs When it should be depreciated. Depreciation Loss limitations on rental properties How do you calculate the gain on your property when selling? Short-Term Gain vs Long-Term Gain when selling Homeowner Exemption Overview of Section 1031 exchanges

What is the difference between rental income and earned income? Rental Income is Passive Income Passive income is an income received on a regular basis, with little effort required to maintain it. Passive Income is not subject to self-employment taxes Earned income includes all the taxable income and wages you get from working Earned income is subject to employment taxes

What is Included in Rental Income Monthly Rental Payments Advanced Rent Any income received from tenants for breaking a lease Any Expenses Paid by Tenant Services in Lieu of Rent Security Deposit a) If you intend on returning the security deposit when tenants move out only report the portion you keep, in any, for damages. b) If the security deposit is last month’s rent, it is treated as Advanced Rent

Internal Revenue Code for Common Expenses IRC 162(a) - Trade or business expenses There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Did I incur this expenses to operate my business? IRC 212 - Expenses for production of income In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income. Did I incur this expense to collect income or produce income?

Common Expenses Advertising Taxes Cleaning & Maintenance Utilities Commissions Interest (other) Legal and other professional fees Local transportation expenses Management fees Repairs Taxes Utilities Mortgage interest paid to banks, etc Points (Pre-Paid Interest) Insurance Interest (other) Depreciation

A Few Notes Insurance premiums paid in advance.   If you pay an insurance premium for more than one year in advance, you cannot deduct the total premium in the year you pay it. Interest expense.   You can deduct mortgage interest you pay on your rental property. When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally cannot be deducted as a rental expense.  Travel expenses.   You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip is to collect rental income or to manage, conserve, or maintain your rental property. You must properly allocate your expenses between rental and nonrental activities. You cannot deduct the cost of traveling away from home if the primary purpose of the trip is to improve the property. The cost of improvements is recovered by taking depreciation. For information on travel expenses, see chapter 1 of Pub. 463. Local transportation expenses.  Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: actual expenses or the standard mileage rate. For 2016, the standard mileage rate for business use is 54 cents per mile. For more information, see chapter 4 of Pub. 463. To deduct car expenses under either method, you must keep records that follow the rules in chapter 5 of Pub. 463. In addition, you must complete Form 4562, Part V, and attach it to your tax return.

Depreciation Depreciation is a capital expense. It is the mechanism for recovering your cost in an income producing property and must be taken over the expected life of the property. The depreciation method for rental homes is Straight-Line 27.5 years. Depreciation begins when a property is placed in service Depreciation is allowed or allowable

Calculating Basis for Depreciation

Settlement Fees Not Included in Basis The following items are settlement fees and closing costs that are treated as business expenses Rent for occupancy of the property before closing. Charges for utilities or other services related to occupancy of the property before closing. Casualty insurance premiums. Escrow payments for taxes & insurance

Settlement Fees Not Included in Basis Charges connected with getting a loan must be capitalized and can be deducted over the period of the loan. The following are examples of these charges. Points (discount points, loan origination fees). Mortgage insurance premiums. Loan assumption fees. Cost of a credit report. Fees for an appraisal required by a lender. Fees for refinancing a mortgage.

Repairs vs Improvements Subject to Depreciation Generally, an expense for repairing or maintaining your rental property may be deducted if you are not required to capitalize the expense. Improvements.   You must capitalize any expense you pay to improve your rental property. An expense is for an improvement if it results in a betterment to your property, restores your property, or adapts your property to a new or different use. Betterments.   Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength, or quality of your property. Restoration.   Expenses that may be for restoration include expenses for replacing a substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.

Improvements Additions  Bedroom  Bathroom  Deck  Garage  Porch  Patio    Lawn & Grounds  Landscaping  Driveway  Walkway  Fence  Retaining wall  Sprinkler system  Swimming pool Miscellaneous  Storm windows, doors  New roof  Central vacuum  Wiring upgrades  Satellite dish  Security system     Heating & Air Conditioning  Heating system  Central air conditioning  Furnace  Duct work  Central humidifier  Filtration system Plumbing  Septic system  Water heater  Soft water system  Filtration system    Interior Improvements  Built-in appliances  Kitchen modernization  Flooring  Wall-to-wall carpeting    Insulation  Attic  Walls, floor  Pipes, duct work

Rental Loss Limitations Passive Loss Limitations, in general Losses from passive activities are limited to the amount of passive gains from other sources. Losses in excess of other passive income will be carried forward Exception for Rental Real Estate Activities With Active Participation You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Rental Loss With Active Participation There is a special allowance of up to $25,000 in losses in excess of passive income with active participation The special allowance is $25,000 for individuals & married couples. It is $12,500 for married filed separately. Special Allowance Limitation If your modified adjusted gross income (MAGI) is in excess of $100,000 then the special allowance is limited by half for each dollar in excess of $100,000. Completely phasing out at $150,000 Example: Individual or Married Filing Jointly MAGI is $130,000 $30,0000 x .5 = $15,000 Special Allowance = $25,000 - $15,000 = $10,000 in allowed losses

Calculating Gain/Loss on Sale of Property Adjusted basis is the rental's purchase price plus buying costs plus improvements plus sales expenses, minus prior-year depreciation.

Short-Term vs Long-Term Capital Gains Short-Term Capital Gains - Property held for less than a year - Taxed at ordinary income tax rates (10% - 39.6%) Long-Term CapitalGains - Property held for more than a year - Taxed at capital gain rates (0% - 20%)

Section 121 Exclusion You may be able to exclude up to $500,000 on the gain of your rental home if you meet the ownership and use test: Ownership & Use Test – You are eligible if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. Unless previously part of 1031 exchange within the previous 5 years. The exclusion is $500k, if married and $250k, if single. You may use the section 121 exclusion every 2 years unless previously part of a 1031 exchange. A benefit of using your rental as a primary residence for the 1st two years is that you do not need a 20% down payment.

Section 121 Exclusion When Converting Primary Residence to Rental Donna has lived in her property as a primary residence since 2008. In 2012, she received a new job opportunity across the country, but decided she didn’t want to sell the property yet as home values were still recovering in her area, so she rented the property instead. Now, in 2014, as home prices have continued to appreciate, she wishes to sell the property. Even though there have been 2 years of otherwise-nonqualifying-use as a rental, Donna does not have to count nonqualifying use that occurred after she lived in the property as a primary residence. As a result, all gains will be treated as qualifying, and eligible for the capital gains exclusion (except to the extent of any depreciation recapture). Even though Donna does not still live in the house as a primary residence, she has still used it as a primary residence in at least 2 of the past 5 years (as she lived there in 2010 and 2011 before renting in 2012), so the Section 121 exclusion is available. However, it’s notable that if Donna waits until 2016 to sell, at that point there will be 4 years of rental use and only 1 year of use as a primary residence, so Donna will lose access to the Section 121 exclusion simply because she no longer meets the 2-of-5 ownership-and-use test.

Section 121 Exclusion when Converting Rental to Primary Residence Harold rented out a property for four years (2009, 2010, 2011, and 2012) and then used it as a primary residence for two years (2013 and 2014) to qualify for the capital gains exclusion, and sell it next year (after meeting the 2- year use test), the total $150,000 of capital gains (above the original cost) must be allocated between these periods of qualifying and non-qualifying use. Since there are only 2 years of qualifying use out of a total of 6 years the property was held, only 1/3rds of the gains (or $50,000) are deemed qualifying (and will be fully excluded, as $50,000 of qualifying gains is less than the $250,000 maximum amount of qualifying gains that can be excluded). As a result of these limitations, the remaining $100,000 of capital gains attributable to nonqualifying use will be subject to long-term capital gains tax rates (along with the $29,000 of depreciation recapture).

Section 1031 (Like-Kind) Exchanges A properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. Any property held for productive use of trade or business or for investment can be exchanged for any other property held for productive use in trade or business or for investment – these properties are considered “like-kind” to one another.  Investor can identify up to 3 properties for the exchange and generally have 6 months to secure one or more of those properties Section 1031 exchanges require a intermediary to hold proceeds of original sale. The intermediary holds profits from original sale until closing of new property It is possible to defer capital gain tax from a Section 1031 Exchange and convert some of that deferred tax into non-taxable income via the Section 121 exclusion.

Resources Publication 527, Residential Rental Property (Including Rental of Vacation Homes) Publication 463, Travel, Entertainment, Gift, and Car Expenses Publication 551, Basis of Assets Publication 523, Selling Your Home