Imagine you are suddenly offered a job in another city, but don't want to sell your house or condo just yet. Should you rent it out for a while? The answer to this question depends not only on your feelings about becoming a landlord, but also on financial and tax considerations.
First of all, rental income is taxable on Schedule E of your individual tax return. Luckily, there are many deductions you can legitimately take:
- Mortgage interest
- Property taxes
- Condo/Homeowner's fees
- Insurance
- Utilities (if you pay them instead of your tenant)
- Repairs (but not improvements to the property)
- Management fees (if you use an agent to rent out the property)
- Other incidental expenses related to the property and its management
A word about depreciation
The IRS states that you may depreciate your residential rental property over 27 ½ years, which is a little over 3.6% annually. Your depreciable basis is your purchase price, improvements or renovations you've done since you purchased the building. However, the land value of your property is not depreciable. By the way, when they say "may", they mean "must", even if the depreciation does not give you a current tax benefit.
Please keep in mind that once you sell the building you will have to recapture depreciation as income subject to income tax of up to 25% in the year of the sale.
Real Estate Rental Losses
Since losses from real estate investment have long served as a tax shelter for the rich by reducing their taxable income, the IRS changed the law on who may take how much in losses on rental properties. If you actively participate in the rental activity, which the IRS clarifies as owning at least 10% of the property and having substantial involvement in managing the rental, then the IRS allows an annual loss of up to $25,000 against your ordinary income. This loss is subject to a phase out, ie. the loss allowance of $25,000 is phased out by 50% of the amount by which your Modified Adjusted Gross Income (MAGI) is above $100,000. The allowance is completely phased out at $150,000 MAGI.
Especially in places like San Francisco you are very unlikely to command rent, which covers all your expenses, and will likely produce a rental loss. Any losses not used in a tax year will be carried forward and may be offset against gains in future years or gains from other passive activities in the same year.
Whether or not to become a landlord depends also very much on your own feelings about the subject. Being a landlord can be a great experience if you have a proactive management company, which takes the day-to-day worries off you. However, if you intend to manage the property yourself and land the tenant from hell, you can step into many legal and financial problems. Don't make this decision lightly, but weigh up all pros and cons first. And as always, consult your financial advisor if in doubt.
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