The tax implications of owning rental property
Many people consider investing in rental real estate to generate a stream of income. This income can be helpful at any stage of life, especially in retirement when it can be an additional source of cash flow to supplement Social Security, pensions, etc.
Like any investment, owning rental real estate has its own set of potential risks and rewards. Furthermore, there are some unique tax implications that come along with owning a rental property.
Not that the tax aspects alone should deter you from investing in rental property but, the tax implications that accompany being a landlord definitely need to be considered before deciding if rentals make sense for you.
One of the main benefits of owning a rental property is receiving a stream of income that’s likely “uncorrelated” to the performance of your other investments. In other words, even if your traditional stock and bond investments are doing poorly, the monthly rent checks from your tenants shouldn’t be impacted much, if at all.
Additionally, potential appreciation in the price of the property is another possible financial benefit; if you buy the property for X and sell it for something more than X, you will have made a profit or realized a gain.
Another aspect of owning a rental property that could be a benefit is the ability to get a tax deduction for certain expenses. Specifically, many rental property owners think it’s great to be able to take annual tax deductions for depreciation. “Depreciation” is an IRS-mandated assumed reduction in value of the property where that reduction is treated as an expense and can therefore be deducted against each year’s rental income.
Depreciation is indeed a nice little tax savings while you own the property. However, when you eventually sell the property, you will essentially have to pay back all of the years of depreciation tax savings you received. In other words, the IRS makes you recapture all the depreciation expenses you deducted along the way. Furthermore, recaptured depreciation is treated as ordinary taxable income, which means you could have a hefty tax bill when you sell your rental.
Also, any gain you have on selling the property will be taxable. Thankfully, such gain is eligible for the reduced long-term capital gains tax rate if you hold the property more than a year before selling it.
Where rental property taxation gets real complicated is if you’ve ever lived in the rental as your primary residence. In that case, there are convoluted rules about pro rating things such as depreciation recapture, taxable gain and the $250,000 (if single) or $500,000 (if married) gain exclusion that applies when selling a primary residence.
For more information on the tax implications of owning and selling rental properties, check out my recent YouTube video, The Basics of Rental Property Taxation.