A rental property can generate “taxable losses” that can be used to reduce your normal salary income, hence the federal income taxes you pay. It’s difficult for most people to understand how taxes work, and even more confusing once we get into the realm of rental properties and taxes. Note that understanding how taxes impact personal residences are a completely different topic, as those are governed by totally separate tax codes and go elsewhere on your 1040 form.
Below are some of the basics to understanding rental properties and federal income taxes.
Often I hear people saying that they want to buy some real estate to save money on income taxes. However, depending on your tax situation, owning real estate might not save you a dime on taxes. It wholly depends on your specific tax picture and the IRS rules about Passive Activity Loss Limitations.
First and foremost you should never make real estate investment decisions based solely on tax considerations. The first order of business is do your due diligence and determine if an investment makes sense based on cash flows, cash on cash returns, renovation costs, rental income, financing, and the risk of any particular property. Once you believe it makes sense in every other sense, then you can contemplate the tax effects.
Important note: Always have a CPA, attorney or licensed tax professional guide you through your individual tax picture — this article is an illustration of one scenario but your scenario can be very different based on your financial picture.
To better understand, let’s first quickly discuss the IRS 1040 form.
The 1040 form you fill out each year does two things:
- Calculates the amount of federal income taxes you owe for the year based on how much you earned in salary, income, wages, profits and distributions — LESS all the deductions (tax “shields”/subtractions) to those totals in the form of losses, deductions and exemptions to get to your Taxable income on Line 43. Then, look at the IRS Tax Tables and determine how much you owe in taxes based on your tax filing status (Single, Married Filing Jointly, etc.) and your Taxable Income.
- Second, it reconciles the amount you owe from #1 above against the amount you have already paid during the year. This is commonly called “withholdings” from your salary, or if you are self-employed, you probably paid quarterly estimated income tax amounts to the IRS during the year.
- If you paid more in #2 than you owe in #1, you get a tax refund!
- If you paid less in #2 than you owe in #1, you write the IRS an additional check!
Tax Considerations of Rental Properties
Rental properties generally show taxable losses for the first many years. That taxable loss is essentially another “deduction” that lowers your taxable income — noted in #1 above — and hence lowers your income taxes.
This chart below shows an example of how a loss would be calculated. For example, this property might show a ($7,500) loss. That loss would filter through your IRS 1040 form, reducing your taxable income, and hence reducing your taxes.
This is how you might save money on taxes by owning rental properties — using losses on your rental real estate to reduce your taxable income, which allows you to pay less in federal income taxes.
How much it reduces your taxes depends on your income and filing status. It is a little complicated and can get very complicated depending on your situation.
There are also limits on how much of a loss on rental property any particular taxpayer can use to “shield” their income. These limits are called Passive Activity Loss Limitations. If your losses are over $25,000 and/or your Adjusted Gross Income is over $100,000, you may not be able to use all of the losses. You may have losses, but you are not allowed to reduce your income with them based on the IRS rules. Consult a professional.
More information on this topic is available here.
Leonard Baron, MBA, is America’s Real Estate Professor®. His unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate owners how to make smart and safe purchase decisions. He is a past lecturer at San Diego State University and teaches continuing education to California real estate agents at The Career Compass.